Indiana Law Review


Three Strikes You're Out: The Effect and
Controversies of the SEC's Attempted Mandate

FOR Greater Independence on Mutual Fund Boards

Stephanie Thielen Eckerle*

Introduction

Mutual funds have become the investment ofchoice for individual investors.'
They allow investors to build a diverse portfolio at a reasonable price. ^ In
America alone, over ninety million people, which equates to half of all
households, invest in mutual funds.^ In 2004, despite the recent multitude of

investment company scandals,"^ mutual fund investments reached a record high
with $7.6 trillion invested,^ including twenty-one percent of the $10.2 trillion

retirement market.^ In 2005, mutual fund assets continued to grow and reached
a record $8.8 trillion in November.^

Despite the rapid and continued growth of mutual funds,^ the Securities and

* J.D. Candidate, 2007, Indiana University School of Law—Indianapolis; B.A., 2004,
Baylor University, Waco, Texas. I would like to thank Professor Antony Page for his assistance

throughout the development of this Note. In addition, I would like to thank my parents, Steve and
Linda Thielen, and my husband, Chris Eckerle, for their continued love and encouragement.

1. Harvey J. Goldschmid, Comm'r, Sec. and Exch. Comm'n, Mutual Fund Regulation: A
Time for Healing and Reform, Speech Before the Investment Company Institute 2003 Securities

Law Developments Conference (Dec. 4, 2003), 2003 WL 23177225, at *1.
2. Roberta S. Karmel, Mutual Funds, Pension Funds, Hedge Funds and Stock Market

Volatility—What Regulation by the Securities and Exchange Commission Act Is Appropriate?, 80
Notre Dame L. Rev. 909, 914 (2005) [hereinafter Karmel, Mutual Funds].

3. Mercer E. BuUard, The Mutual Fund Summit: Context and Commentary, 73 MiSS. L.J.

1129,1130(2004).

4. See Sec. AND EXCH. COMM'N, EXEMPTIVE RULE AMENDMENTS OF 2004: INDEPENDENT

Chair Condition, A Report in Accordance with the Consoudated Appropriations Act,
2005 SEC Lexis 1031, at *3 (2005) [hereinafter Report EM AccordanceWITHthe Consolidated

Approprl\tions Act]. Since 2003, the SEC has acquired over $2.2 billion in disgorgements and

civil penalties from enforcement actions brought against investment companies. Id. This money

is being used to compensate shareholders adversely affected by the mutual fund scandals. Id. ; see

Investment Company Governance, 70 Fed. Reg. 39,390, 39,399 (Sec. and Exch. Comm'n July 7,

2005) (Donaldson, concurring) (to be codified at 17 C.F.R. pt. 270) (response to remand).

5. Bullard, supra note 3, at 1 130.

6. Goldschmid, j:M/7ra note 1, at *1.

7. Trends in Mutual Fund Investing, November2005, INV. Co. iNST. (Dec. 29, 2005), http://

www.ici.org/stats/mf/arctrends/trends_ll_05.html.

8. See generally BRIAN REID ET AL., INV. Co. INST., 2005 INVESTMENT COMPANY FACT

Book (45th ed. 2005), available ar http://www.ici.org/pdfi'2005_factbook.pdf. In 2004, the average

household invested 19.5% of its household financial assets in mutual funds compared to only 6.8%

of household financial assets invested in 1990. Id. at 12. Furthermore, the number of investment

companies holding mutual funds has increased from 5725 in 1995 to 8044 in 2004, and the total

assets of those investment companies has increased from $2,81 1 billion in 1995 to $8,107 billion



150 INDIANA LAW REVIEW [Vol. 40: 149

Exchange Commission (the "SEC") took aggressive action in 2004 to address

perceived failures within the corporate structure of investment companies by

promulgating new regulations (the "New Rules") under the Investment Company
Act of 1940 (the "ICA").^ The New Rules, which were originally to take effect
in January 2006, require a mutual fund's board of directors to be composed of

seventy-five percent independent directors, including the chair, as opposed to

only a majority ofindependent directors. ^° Although the perceived failures in the

mutual fund industry are based on recent SEC enforcement actions addressing the
late trading of mutual fund shares, illegitimate market timing, and the

exploitation of undisclosed details about fund portfolios, ^^ the New Rules may
not have prevented such abuses and do not address many of the recent mutual
fund scandals.'^ The SEC, however, believes that the New Rules are a proactive
and essential measure to protect shareholders by strengthening the independence

of fund boards, thereby reducing inherent conflicts of interest and forcing the

fund's management to abide by all compliance standards. ^^ In addition, the New
Rules are an attempt to restore a perceived lack of integrity, trust, and fairness

in the mutual fund industry. ^"^ The SEC's motivation in passing the New Rules,
however, appears to be not only slightly politicized,^^ but also seems to overlook

the significant cost that the New Rules will likely impose on investors. ^^

The core of the SEC's New Rules focuses on two extremely controversial
provisions that have sparked a firestorm ofcomments and criticism. Pending the

outcome of the New Rules, all investment companies that transact under the
Exemptive Rules of the ICA must alter their board of directors to be seventy-five

in 2004. Id. at 3, 9.

9. Investment Company Governance, 69 Fed. Reg. 46,378, 46,378-79 (Sec. and Exch.

Comm'n Aug. 2, 2004) (to be codified at 17 C.F.R. pt. 270) (final rule).

10. Id.

11. Id.

12. Id.\ Chamber of Commerce v. Sec. and Exch. Comm'n {Chamber I), All F.3d 133, 141

(D.C. Cir. 2005); see Karmel, Mutual Funds, supra note 2, at 934 (explaining that many of the

enforcement actions the SEC has brought against mutual funds have involved hedge funds, which

are not regulated by the ICA and thus are not subject to the New Rules).

13. Investment Company Governance, 69 Fed. Reg. at 46,379 (final rule).

14. Goldschmid, supra note 1, at *2. Recent studies, however, indicate that investor

confidence in the mutual fund industry has risen over the past two years after a decline in 2000

through 2003. Fundamentals, Investment Company Institute Research in Brief, Shareholder

Sentiment About the Mutual Fund Industry, 2005, 14 INV. Co. iNST. 7 (2005), available at

www.ici.org/stats/res/index.hml (follow "More Issues of Fundamentals" hyperlink; then follow

"Shareholder Sentiment About the Mutual Fund Industry, 2005 (pdf) December 2005" hyperlink).

15. Roberta S. Karmel, Key Outcomes of "Chamber of Commerce v. SEC, " N.Y. L.J., Aug.

18, 2005, at Col. 1, *1 [hereinafter Karmel, Key Outcomes]; see Jonathan R. Macey, State-Federal

Relations Post-Eliot Spitzer, 70 Brook. L. Rev. 117, 136-37 (2004).

1 6. See Investment Company Governance, 69 Fed. Reg. at 46,390 (final rule) (Glassman and

Atkins, dissenting).



2007] CORPORATE GOVERNANCE OF MUTUAL FUNDS 1 5

1

percent independent/'' as well as elect or nominate an independent chair to the

board of directors.'^ Not only did the SEC receive over 200 comments from
investors, management companies, directors of mutual funds, and members of
Congress,*^ but the New Rules only passed the Commission by a 3-2 vote with
Commissioners Cynthia A. Classman and Paul S. Atkins dissenting.^^ The
numerous comments and strong dissent foreshadowed the intensive scrutiny and
debate that was to follow, which culminated in a lawsuit brought against the SEC
by the Chamber of Commerce.^' This lawsuit and the subsequent actions of the
SEC resulted in the Court of Appeals for the District of Columbia ("D.C.
Circuit") remanding the New Rules back to the SEC on two separate occasions.^^

Part I of this Note sets forth the general corporate structure of mutual funds

17. An independent director is a director that is non-interested, meaning that he is not

affiliated with the investment company, is not an immediate family member of anyone in the

investment company, is not affiliated with the investment adviser or principal underwriter, and has

not acted as legal counsel for the investment company within the preceding two years. 15 U.S.C.

§ 80a-2(a)(3) (2000). A person is affiliated with an investment company if he owns over five
percent or more of the outstanding voting securities. Id.

18. Investment Company Governance, 69 Fed. Reg. at 46,38 1 -82 (final rule); see generally

Thomas R. Hurst, The Unfinished Business ofMutual Fund Reform, 26PACEL. Rev. 133, 143-45,

152 (2005) (summarizing the SEC's New Rules, the controversy surrounding the New Rules, and

the possible effects of the New Rules on investor protection); David S. Ruder, Balancing Investor

Protection with Capital Formation Needs After the SEC Chamber ofCommerce Case, 26 PACE L.

Rev. 39 (2005) (explaining the SEC's analysis of capital formation in passing the seventy-five

percent independent board and chair requirements and past efforts of the SEC to analyze the effect

that its rules and programs have on capital formation).

19. Investment Company Governance, 69 Fed. Reg. at 46,379 (final rule). Both Congressman

Mike Oxley and Senator Paul Sarbanes, authors of the Sarbanes-Oxley Act, support the New Rules

due to the added protection afforded to investors. Investment Company Governance, 70 Fed. Reg.

39,390, 39,401 (Sec. and Exch. Comm'n July 7, 2005) (Campos, concurring) (to be codified at 17

C.F.R. pt. 270) (response to remand).

20. Investment Company Governance, 69 Fed. Reg. at 46,390-93 (final rule).

21. See Chamber 1, 412 F.3d 133 (D.C. Cir. 2005). Any party adversely affected by an SEC

rule promulgated under certain sections of the ICA may file suit against the SEC. See 15 U.S.C.

§ 78y(b) (2000); Thomas Lee Hazen, 5 Law of SECURirms Regulation § 16.22 (5th ed. 2000).
The Chamber ofCommerce is an adversely affected party and has standing to sue because the New

Rules will prevent members of the Chamber of Commerce from investing in mutual funds that do

not have an independent chair or seventy-five percent independent directors, and thus suffer an

"injury-in-fact." Chamber I, 412 F.3d at 138. In addition, the historical data showing that

management-chaired funds perform slightly better than funds with independent chairs and that the

New Rules could prevent small funds from entering the mutual fund market also support the

Chamber of Commerce's standing. Chamber of Commerce v. Sec. and Exch. Comm'n (Chamber

ID, 443 F.3d 890, 896-97 (D.C. Cir. 2006).

22. After the D.C. Circuit originally remanded the New Rules in Chamber I, the SEC quickly

readopted the New Rules. In Chamber II, the D.C. Circuit again remanded the New Rules back to

the SEC. 443 F.3d at 909.



152 INDIANA LAW REVIEW [Vol. 40: 149

and the legislative history of mutual fund regulation. This part focuses not only

on the relationship between investment companies and their management, but
also the inherent conflicts of interest between mutual fund managers and

shareholders.

Part II explains the New Rules as originally proposed by the SEC,
specifically the seventy-five percent independent board and chair requirements.

This section then analyzes the D.C. Circuit's interpretation of the SEC's
controversial provisions under the ICA and the Administrative Procedure Act
(the "APA") in the case of Chamber /, and the SEC's re-adoption of the New
Rules only eight days after the D.C. Circuit remanded the provisions back to the
SEC. In addition. Part 11 examines the reaction of both the Chamber of
Commerce and the public to the SEC's swift re-adoption of the New Rules and
the D.C. Circuit's second remand of the New Rules in Chamber II.

Part III analyzes why the New Rules do not optimally achieve the goals of the
SEC and examines the effectiveness of the SEC's prior rules that are aimed at
protecting investors, including the 2001 amendment to the ICA requiring a
majority of independent directors. This section also includes an analysis of the

impact that the New Rules would have had on the recent mutual fund scandals,
the lack of empirical evidence upon which the SEC based the new rules, and the
disclosure alternative. In conclusion, this Note examines the adverse short-term

and long-term implications that the holdings in Chamber I and Chamber II will
have on the New Rules and future rule-making procedures of the SEC.

I. The Corporate Structure and Legislative History
OF Mutual Funds

A. Corporate Structure ofInvestment Companies

Conflicts of interest are inherent in mutual funds;^^ therefore, it is vital to

understand the corporate structure that causes these problems. A mutual fund is
a collection of assets consisting mainly of various and diverse securities owned
by individual shareholders that have invested in shares of the mutual fund.^"^

Mutual funds are controlled, managed, and formed^^ by investment companies,

such as Fidelity Investments ("Fidelity"). These investment companies invest,

reinvest, or trade in securities on behalf of the shareholders,^^ and the

investments by the shareholders supply the money needed by the investment
company to continue investing in the diverse securities.^^ The investment

23. SeeKarmel, Mutual Funds, supra notQ 2, ai 914.

24. Burks v. Lasker, 441 U.S. 471, 480 (1979); Chamber I, 412 F.3d at 136.

25. Burks, 441 U.S. at 4Sl.

26. See 15 U.S.C. § 80a-3 (2000); see also David J. Oliveiri, Annotation, What Is an

"Investment Company" Under § 3 ofInvestment Company Act of1940 (15 U.S.C.A. § 80a-3), 64

A.L.R. Fed. 337(1983).

27. iNv. Co. Inst., A Guide to Understanding MutualFunds 6 (2004), http://www.ici.
org/pdf/bro_understanding_nifs_p.pdf.



2007] CORPORATE GOVERNANCE OF MUTUAL FUNDS 1 53

company usually has separate underwriters and no employees.^^ In addition, each
mutual fund within an investment company has specific goals and is managed by
an external entity, called an investment adviser.^^ The investment adviser,
pursuant to a contract with the investment company, chooses or recommends all
of the mutual fund's investments^^ and provides administrative and management
services.^'

Investment advisers have other goals beyond increasing the shareholder's

return, which is where the inherent conflict of interest arises.^^ Because the

management company and investment advisers are external from the investment
company, the investment adviser's loyalty and monetary gain are outside the

fund; thus, their interest in their own profits may be adverse to the interest of the
mutual fund and the shareholders.^^ An investment adviser typically profits by
receiving a fee based upon a percentage of assets in the mutual fund that is under
his management.^'* Consequently, investment advisers are concerned with

increasing and maximizing the assets in the mutual funds that they advise, thus

increasing their compensation.^^ Shareholders, however, are concerned with

28. Karmel, Mutual Funds, supra note 2, at 914.

29. Burks, 44\V.S. at 4%\.

30. 15 U.S.C. § 80a-2 (2000).

31. Burks,44l U.S. at 481 (quoting S. REP. No. 91-184, at 5 (1969)). For example. Fidelity,

an investment company, has over three hundred Fidelity mutual funds, and thousands of non-

Fidelity funds, that investors can choose from when investing. Fidelity Research and Management

Company ("FMR Co.") manages all of Fidelity's mutual funds. Fidelity, Inside Fidelity,

http://personal.fidelity.com/myfidelity/InsideFidelity/index.html (follow "Company Overview"

hyperlink; then follow "Investment Management" hyperlink) (last visited Sept. 18, 2006). FMR
Company employs over five hundred investment specialists, including both investment advisers and

analysts, that research investment strategies and new investment opportunities. Id. For example,

Fergus Shiel, an employee ofFMR Company and an investment adviser, manages Fidelity ' s Capital
Appreciation Fund, one of Fidelity's top performing mutual funds. The investment advisers often

manage more than one mutual fiind. Fidelity, Fidelity Capital Appreciation Fund,

http://personal.fidelity.com/products/funds/mfl_frame.shtml7316066109 (last visited Sept. 18,

2006). The Capital Appreciation Fund has the goal of obtaining capital appreciation by investing

in securities, which consist of mainly foreign and domestic stock. Id. Fergus Shiel and his staff

choose the stocks for the mutual fund by analyzing the stock's financial state, industry position, and

other market and economic forces. Id.

32. Chamber 1, 412 F.3d 133, 136 (D.C. Cir. 2005). For example, a conflict of interest arises

when the investment adviser encourages private investors to deposit new assets into the fund in

exchange for abusive market timing privileges. Report in AccordancewiththeConsolidated

Act, supra note 4, at *1 1, 73.

33. Investment Company Governance, 70 Fed. Reg. 39,390, 39,396 (Sec, and Exch. Comm'n

July 7, 2005) (to be codified at 17 C.F.R. pt. 270) (response to remand); 15 U.S.C. § 80a- 17 (2000).

34. Report in Accordance with the Consolidated Appropriations Act, supra note 4,

at*ll.

35. Id.



154 INDIANA LAW REVIEW [Vol. 40:149

having a profitable mutual fund, as opposed to a large mutual fund.^^ This

inherent conflict of interest has led numerous investment advisers to encourage

private investors to deposit large sums of money into a mutual fund, thus
increasing the mutual funds' assets and the investment adviser' s compensation.^^

The investment adviser then gives the private investor illegal or abusive
privileges, such as market timing privileges, which harms other shareholders.^^

Section 17 of the ICA addresses and forbids certain "self-dealing
transactions" in order to reduce the inherent conflict of interest that arises

between shareholders and mutual fund investment advisers.^^ The ICA, however,
does not address all conflicts of interest that can arise, such as "the allocation of

brokerage commissions, the use of fund assets for distribution, the allocation of

expenses between a fund and its adviser and among funds, responsibility for any
pricing errors or violations of investment restrictions, and personal investing by

officers and employees ofthe fund' s adviser.'"^^ Therefore, in order to assure that

the mutual fund's investment adviser is acting in the best interest of the

shareholder, a board of directors elected by the shareholders governs the mutual

fund."^' The ICA and various SEC regulations, orders, and interpretations
stringently govern fund directors, whether independent or affiliated with the

management company
."^^

The board of directors has the responsibility of, among other things, valuing
the securities held by the fund, approving the fund's investment advisory and

principal underwriter contracts, approving distribution plans under Rule 12b-l

of the ICA,"^^ and generally overseeing any transaction that the Exemptive Rules

govem.'^'^ The board of director's main goal, however, is to ensure that the fund's

36. Shareholders would only be concerned with increasing the assets of the mutual fund "to

the extent that the increase [in assets] achieves the economies of scale that should reasonably

accompany fund growth." Id.

37. Id.

38. Id.

39. InvestmentCompany Institute, Reportofthe AdvisoryGrouponBestPractices

FOR Fund Directors, Enhancing a Culture of Independence and Effectiveness 8 (1999),

available at http://www.ici.org (follow "Key Issues" hyperlink; then follow "Directors & Fund
Governance" hyperlink; then follow "Report of the Advisory Group on Best Practices for Fund

Directors (pdf) June 1999" hyperlink) [hereinafter INVESTMENT Company Institute, Fund

Directors].

40. Id. at 9.

41. Chamber I 412 F.3d 133, 136 (D.C. Cir. 2005).

42. Investment Company Institute, Fund Directors, supra note 39, at 6; Report in

Accordance with the Consolidated Approprl\tions Act, supra note 4, at *12, 14-15.

43. The board of directors should closely monitor the 12b-l distribution plans because an

investment adviser can charge higher 1 2b- 1 fees in order to maximize fund assets, and thus increase

the fee paid to the adviser. Report in Accordance with the Consolidated Approprl\tions

Act, supra note 4, at * 1 2, * 1 4- 1 5 ; INVESTMENTCOMPANYINSTITUTE, FUNDDirectors, supra note

39, at 6-7.

44. Report in Accordance withthe Consolidated Approprl\tions Act, supra note 4,



2007] CORPORATE GOVERNANCE OF MUTUAL FUNDS 155

investment adviser is acting in the best interest of the shareholders, and that the

shareholders are obtaining the benefits and services they are entitled to under the

ICA and the fund's prospectus and disclosure documents."^^

B. History ofMutual Fund Regulation

The main goal of Congress in passing the ICA was to diminish the inherent
conflicts of interest between investment advisers and shareholders."^^ The key
provision of the ICA requires a mutual fund's board of directors to be composed
of at least forty percent independent directors to serve as "watchdogs" by
independently checking and monitoring the mutual fund's management.'*^ This

independent check works to ensure that the investment advisers are not engaging

in transactions for their own self-interest at the detriment of the shareholder.'*^
In addition, under the ICA both investment advisers"^^ and mutual fund directors
owe the fiduciary duties of care, good faith, and loyalty to the shareholders.^° If
an investment adviser or director violates a fiduciary duty, the SEC can bring an
action against him resulting in, among other things, permanent or temporary
enjoinment of his position within the investment company.^^

The ICA allows mutual funds to engage in prohibited transactions if the fund
adheres to the specific Exemptive Rules set forth in the ICA.^^ Adherence to

these rules allows mutual funds to transact with affiliated companies, which is

necessary for most mutual funds to conduct business.^^ Because the vast majority

of mutual funds must adhere to these rules to thrive,^"* the SEC is able to impose
new regulations on virtually all funds by incorporating the regulations into the

at*129.

45. Investment Company Institute, Fund Directors, supra note 39, at 6-7.

46. See Burks v. Lasker, 441 U.S. 471, 480-81 (1979); Chamber I, 412 F.3d at 136-37;

Investment Company Institute, Fund Directors, supra note 39, at 6.

47. Burks, 41 1 U.S. at 482, 484. The reference to the independent directors as "watchdogs"

by the Supreme Court has been quoted in numerous authorities, many of which are cited in this

Note.

48. C/iflm^er/,412F.3datl36.

49. 5ee 15 U.S.C. § 80b-6 (2000).

50. Goldschmid, supra note 1, at *5; see Diane E. Ambler, Roundtable on the Role of

Independent Investment Company Directors: Issues for Independent Directors of Bank-Related

Funds, Variable Insurance Product Funds, and Closed-End Funds, 55 Bus. LAW. 205, 210-1

1

(1999); see also Bullard, supra note 3, at 1 141.

51. 15 U.S.C. § 80a-35 (2000).

52. Chamber 1,412 F.3d at 136. Under the ICA, the SEC has the power to exempt any

person, security, or transaction from the rules and regulations of the ICA if the exemption is in the

best interest of the public and protects investors. 15 U.S.C. § 80a-6(c) (2000); Report in

Accordance with the Consolidated Appropriations Act, supra note 4, at *19.

53. Karmel, Mutual Funds, supra note 2, at 916.

54. See Initial Opening Brief of Petitioner at 9, Chamber of Commerce v. Sec. and Exch.

Comm'n, 412 F.3d 133 (D.C. Cir. 2005) (No. 04-1300).



156 INDIANA LAW REVffiW [Vol. 40:149

Exemptive Rules.
^^

C. Recent Amendments to the Investment Company Act

In 2001, the SEC amended the ICA by requiring investment companies to
have a majority of independent directors on the board, as opposed to only forty

percent.^^ The independent directors have the responsibility of, among other
things, selecting and nominating new independent directors and hiring attorneys
with no connections to the mutual fund's management.^^ While the SEC was
passing this amendment, it was simultaneously trying to pass new regulations
requiring more independence on corporate boards under the Sarbanes-Oxley
Act.^«

More recently, the SEC has required mutual funds to hire a chief compliance
officer ("CCO")-^^ The CCO is required to meet with only the independent
directors, as opposed to the entire board and submit a report on compliance

issues to the full board.^^ Likewise, a mutual fund's attorneys are now required
to report any compliance or fiduciary breaches to the independent directors and

the CCO.^^ This not only gives the independent directors greater control over the

investment advisers, including the ability to solve conflicts of interest and

compliance breaches, but also enables the open flow of information.^^

n. The SEC's New Rules Requiring an Independent Chair
AND Seventy-Five Percent Independence on The Board of Directors

A. The New Rules as Originally Proposed

The SEC's New Rules require a mutual fund's board of directors to be
comprised of at least seventy-five percent independent directors, including an

independent chair of the board.^^ The three commissioners that voted in favor of

55. Investment Company Governance, 69 Fed. Reg. 46,378, 46,390 n.l (Sec. and Exch.

Comm'n Aug. 2, 2004) (Classman and Atkins, dissenting) (to be codified at 17 C.F.R. pt. 270)

(final rule).

56. Investment Company Governance, 69 Fed. Reg. at 46,378 (final rule); Karmel, Mutual

Funds, supra note 2, at 930.

57. Investment Company Governance, 69 Fed. Reg. at 46,378 n.2 (final rule); Karmel,

Mutual Funds, supra note 2, at 93 1

.

58. Karmel, Mutual Funds, supra note 2, at 930; see Hurst, supra note 18, at 144, 152.

59. Compliance Programs of Investment Companies and Investment Advisers, 68 Fed. Reg.

74,714, 74,721 (Sec. and Exch. Comm'n Dec. 24, 2003) (to be codified at 17 C.F.R. pts. 270, 275,

279); Goldschmid, supra note 1, at *4.

60. Compliance Program of Investment Companies and Investment Advisers, 68 Fed. Reg.

at 74,721; see Goldschmid, supra note 1, at *4; see Karmel, Mutual Funds, supra note 2, at 932.

61. Goldschmid, supra note 1, at *4.

62. See id.

63. Investment Company Governance, 69 Fed. Reg. 46,378, 46,381-82 (Sec. and Exch.

Comm'n Aug. 2, 2004) (to be codified at 17 C.F.R. pt. 270) (final rule). If, however, the board of



2007] CORPORATE GOVERNANCE OF MUTUAL FUNDS 1 57

the New Rules, Chairman Donaldson, Commissioner Goldschmid, and
CommissionerCampos (collectively the "Majority Commissioners"), believe that
the amendments will enable the independent directors to take and preserve
control over the board, and thus better fulfill their fiduciary duties and address

conflicts of interest by monitoring the investment advisers.^'* If the independent

directors do not have control over the board nor access to vital information

regarding the mutual fund, the directors affiliated with the management company
would be in a position to control the agenda of the board^^ and possibly allow or
overlook conflicts of interest.

The SEC s independent chair requirement is considered the "capstone" ofthe
2004 mutual fund reforms.^^ The Majority Commissioners believe that an
independent chair can effectively protect the shareholders due to the absence of

any conflicts of interest,^^ unlike a chair that also is an executive of the

management company.^^ The independent chair can enable an open and
beneficial dialogue between the affiliated and independent directors during board

meetings and provide another independent check on the fund management;

therefore, protecting the long-term interest of the shareholders.^^

Under the ICA, the SEC has a statutory obligation to ascertain the economic
implications of the New Rules, including the effect the New Rules would have
on efficiency, competition, and capital formation.^^ In the first proposal of the

New Rules, the SEC included a cost-benefit analysis.^* When analyzing the cost
of the seventy-five percent independence requirement, the SEC merely listed the
three different ways in which a board could comply with the New Rules.'^ The
SEC then stated, "our staffhas no reliable basis for determining how funds would
choose to satisfy this requirement and therefore it is difficult to determine the

costs associated with electing independent directors."^^ Likewise, in requiring

an independent chair, the SEC stated, "our staff is not aware of any out-of-pocket
costs that would result . . . because these requirements could be satisfied at a

directors has only three members, two of those three must be independent. Id. at 46,386.

64. /rf. at 46,382.

65. Id.

66. Investment CompanyGovernance, 70 Fed. Reg. 39,390, 39,399 (Sec. and Exch. Comm'n

July 7, 2005) (Donaldson, concurring) (to be codified at 17 C.F.R. pt. 270) (response to remand).

67. Investment Company Governance, 69 Fed. Reg. at 46,382 (final rule).

68

.

Report in Accordance with the Consolidated Appropriations Act, supra note 4,

at *133; see also Investment Company Governance, 70 Fed. Reg. at 39,399 (Donaldson,

concurring) (response to remand).

69. Investment Company Governance, 70 Fed. Reg. at 39,399 (Donaldson, concurring)

(response to remand).

70. Chamber I 412 F.3d 133, 142-44 (D.C. Cir. 2005); 15 U.S.C. § 80a-2(c) (2000); see

Ruder, supra note 18, dX passim.

71. Investment Company Governance, 69 Fed. Reg. at 46,385-87 (final rule).

72. Mat 46,387.
73. Id. at 46,387; ChamberH 443 F.3d 890, 894 (D.C. Cir. 2006).



158 INDIANA LAW REVIEW [Vol. 40: 149

regularly scheduled board meeting."^"^

The SEC, in the first proposal, stated that the New Rules would have no
"significant effect" on efficiency, competition, and capital formation because of

the perceived minimal economic impact/^ The Majority Commissioners believe
the only impact that the New Rules might have on competition and capital
formation is an increase in investor confidence due to the prevention of potential

securities fraud, such as late trading and market timing.^^

B. Chamber I

At issue in the Chamber of Commerce's initial lawsuit were the two
controversial provisions.^'' The Chamber ofCommerce claimed that by adopting
the New Rules, the SEC went beyond its scope of authority under the ICA and
abused its rulemaking power under the APA.^^ The D.C. Circuit held that the
SEC had the authority to adopt the provisions under the ICA;^^ however, the SEC
violated the APA by failing to consider the cost imposed upon shareholders '^°

and failing to consider the disclosure alternative proposed by the dissenting

commissioners.^' The SEC was not required to base its decision on empirical
data, including a study conducted by Fidelity, but did have an obligation to

estimate the cost to individual mutual funds.^^ Thus, the D.C. Circuit remanded

the New Rules back to the SEC for compliance with the ruling.^^ In addition, the
SEC also had to justify the New Rules by providing a comprehensive report to
the Senate Appropriations Committee.^"^

74. Investment Company Governance, 69 Fed. Reg. at 46,387 (final rule).

75. 5^^ /J. at 46,388.

76. Id. at 46,388-89. Former SEC Commissioner Roberta Karmel, has described late trading

as "permitting a purchase or redemption order received after the 4:00 p.m. pricing of a mutual

fund's net asset value[,]" and market timing as "the frequent buying and selling of mutual fund

shares to take advantage of price disparities between a mutual fund's portfolio securities and the

reflection of that change in the fund's share price." Karmel, Mutual Funds, supra note 2, at 929-30.

Although market timing is not illegal, it can harm shareholders by reducing the value of their

shares. In re Federated Inv. Mgmt. Co., Federated Sec. Corp. and Federated S'holder Serv. Co.,

Investment Advisers Act of 1940 Release No. 2448, Investment Company Act of 1940 Release No.

27,167, at *7-8 (Nov. 28, 2005).

77. Chamber I 412 F.3d 133, 136 (D.C. Cir. 2005); Hurst, supra note 18, at 143-44.

78. Hurst, supra note 18, at 138; see also Ruder, supra note 18, at 47.

79. Chamber I, 412 F.3d at 141; see also Ruder, supra note 18, at 47.

80. Chamber /, 412 F.3d. at 144; Hurst, supra note 18, at 143.

8 1

.

Chamber /, 412 F.3d at 144-45; see also Ruder, supra note 1 8, at 49.

82. Chamber 1,412 F.3d at 142-44; see also Ruder, supra note 1 8, at 48-50 (noting that the

D.C. Circuit's holding that the SEC did not need empirical data to base the New Rules was crucial

because had the court held otherwise, "the effect would be to deny [the SEC] power to make rules

in the absence of available data").

83. Chamber I, 412 F.3d at 145.

84. Consolidated Appropriations Act of 2005, Pub. L. No. 108-447, 1 18 Stat. 2809, 2910



2007] CORPORATE GOVERNANCE OF MUTUAL FUNDS 1 59

C Actions of the SEC After Chamber I
The SEC typically takes months to respond to a court's ruling; however, the

New Rules were re-adopted by the SEC only eight days after Chamber I and only
one day prior to Chairman Donaldson's planned retirement.^^ Chairman
Donaldson believed that the quick re-adoption was not rushed, but rather it
protected investors, enhanced investor confidence, and precluded the New Rules
from being left in a state of limbo.^^ In addition, the SEC has a reputation for
meeting deadlines and in the past has acted with expediency on matters that it

believes to be of the utmost importance.^^ Commissioner Classman, however,

stated that the sudden re-adoption was a "rush to judgment" and based on "an
assembly of false statements, unsupported assumptions, flawed analysis, and

mismterpretations

.

The SEC believed that the threshold question from Chamber I was whether
it was essential to conduct additional fact finding and further notice and comment
on the New Rules.^^ The SEC mistakenly concluded that no further public
comment was necessary since it had received comments relating to both the cost
and disclosure alternative and instead relied on the original record.^^ The SEC
also relied on publicly available information.^^ The publicly available
information to which the SEC referred included a widely used "industry survey"
to estimate the cost of compliance for the independent chair requirement.^^

Commissioner Classman and Atkins' s strongly worded dissents to the SEC s
re-adoption after Chamber I highlight both the perceived procedural and

(2004).

85. Monica Gagnier, Donaldson's Parting Shot, Bus. Wk., July 4, 2005, at 44; see

Investment Company Governance, 70 Fed. Reg. 39,390, 39,391 (Sec. and Exch. Comm'n July 7,

2005) (to be codified at 17 C.F.R. pt. 270) (response to remand). Critics viewed the SEC's re-

adoption ofthe New Rules one day prior to Chairman Donaldson' s planned retirement as a political

maneuver. The Majority Commissioners, however, stated that this rushed re-adoption was

necessary because ofthe familiarity the SEC commissioners had with the New Rules due to the year

and a half they had spent studying and researching them. Id.

86. Investment Company Governance, 70 Fed. Reg. at passim (response to remand).

87. Id. at 39,402-03 (Campos, concurring). For example, ten days prior to Chairman Pitt's

retirement in 2003, the SEC enacted ten rules, several of them being final rules or comments. Id.

Moreover, in 2003, due to the Sarbanes-Oxley Act, the SEC conducted more rulemaking in one

year than they had done in any other decade. Id.

88. Robert Schmidt, SEC Resuscitates its Mutual Fund Governance Rule Move Rushed by

Donaldson, Critics Claim, GLOBE AND MAIL, June 30, 2005, at B15.

89. Investment Company Governance, 70 Fed. Reg. at 39,390 (response to remand).

90. Id. at 39,390-91. The Commission stated that not only was further public comment

unnecessary, but it would also harm investors because of the sufficiency of the current information

and the cost of additional fact-finding. Id. at 39,391.

91. Mat 39,390.
92. Chamber II, 443 F.3d 890, 895 (D.C. Cir. 2006).



1 60 INDIANA LAW REVIEW [Vol. 40: 149

substantive errors.^^ Both dissents are highly critical of the actions of Chairman
Donaldson and the swift re-adoption of the New Rules.^"^ On the same day that
the D.C. Circuit remanded the New Rules, Chairman Donaldson's staff
concluded only hours after the remand that the SEC's previous record was
adequate to satisfy the Court' s instructions.^^ CommissionerClassman explained

that these actions, along with others taken in the week before the re-adoption,
elevated "form over substance once again" and were a result of the Majority

Commissioners' fears that the SEC would not re-adopt the New Rules absent
Chairman Donaldson.^^ Both Commissioner Atkins and Classman believe that

a more methodical and deliberate approach, such as roundtable discussions,
further public comment, and formal or empirical surveys, should have been taken

by the SEC in response to Chamber I?^
When re-adopting the New Rules the SEC was forced to justify why the New

Rules were cost-efficient, which it did with information that the SEC claimed to
have had in the original record and through publicly available information.^^ The
cost of the independent chair cited by the SEC includes hiring additional
employees and an independent attorney, recruitment costs, and the increased

salary demanded by independent chairs.^^ Mutual funds, however, may lessen
this cost by choosing the new independent chair from the currently presiding
independent directors.'^ The cost of hiring new independent directors also
includes recruitment costs, additional yearly compensation,'^' and additional

independent attorneys. '^^ According to the Chamber ofCommerce, however, the

93. Investment Company Governance, 70 Fed. Reg. at 39,403, 39,405-06 (Glassman and

Atkins, dissenting) (response to remand).

94. Id. at 39,403 (Glassman, dissenting).

95. Id.

96. Id. In addition. Chairman Donaldson elevated form over substance by departing from

normal procedures regarding "sunshine notices" of open meetings as proscribed in the Code of

Federal Regulations and requiring Commissioners Glassman and Atkins to submit their dissents

prior to the meeting. Id. Commissioner Glassman and Atkins were also given the final release to

be considered at the meeting where the vote for re-adoption would take place the night before the

meeting, thus giving them less than twenty-four hours to reconsider the New Rules. Id. at 39,406
(Atkins, dissenting).

97. Id. at 39,408 (Atkins, dissenting).

98. /^. at 39,391.

99. Opening Brief of Petitioner-Appellant at 22, Chamber of Commerce v. Sec. and Exch.

Comm'n, 412 F.3d 133 (D.C. Cir. 2005) (No. 05-1240).

1 00. See Report inAccordancewffhtheConsolidatedAppropriations Act, supra note

4, at* 146.

101. In 2002, the median compensation for an independent director at a large mutual fund was

$1 13,000 a year, while the compensation at smaller mutual funds was $18,000 a year. Investment

Company Governance, 69 Fed. Reg. 46,378, 46,391 n.24 (Sec. and Exch. Comm'n Aug. 2, 2004)

(to be codified at 17 C.F.R. pt. 270). This does not include recruitment costs or non-compensation

costs. Id.

102. Investment Company Governance, 70 Fed. Reg. at 39,392 (response to remand).



2007] CORPORATE GOVERNANCE OF MUTUAL FUNDS 1 6

1

SEC based these costs on information that is outside the record, extremely
subjective, and in a few instances, even biased.'"^

The monetary cost for replacing an affiliated director with an independent
director is approximately $400,000 per mutual fund board for the first year, while

the cost of changing the board composition to seventy-five percent independent

is approximately $650,000 for the first yearJ^"^ Although nearly sixty percent of

mutual fund boards meet the seventy-five percent independent board

requirement, eighty percent of mutual fund boards, which is approximately 3700
funds, will have to elect or nominate a new independent chair. '^^ This includes
the two largest investment companies. Vanguard and FidelityJ^^ This equates to

a cost of over one million dollars for a mutual fund that has to change both the

board composition and the affiliated chair to an independent chair; a sum which
is even more burdensome for smaller mutual funds. ^°^ Moreover, there are also
non-monetary costs such as the knowledge and expertise that is lost by not

having an affiliated chair.
'^^

D. Reaction of the Chamber of Commerce and the D.C. Circuit to the
SEC's Subsequent Actions

On September 21, 2005, the Chamber of Commerce again filed a brief with
the D.C. Circuit asking it to review the SEC's re-adoption and strike down the
seventy-five percent independent board and chair requirements. '°^ The President
and CEO of the Chamber of Commerce, Thomas Donahue, was outraged at the
SEC s actions and stated "[t]he SEC didn't meet their [sic] legal requirements the

Although additional staff hired by the independent directors has been said to be an additional cost,

the New Rules do not require the hiring of this staff; instead, it is at the discretion of the directors.

See Report in Accordance wfth the Consoudated Appropriations Act, supra note 4, at

*147.

103. Opening Brief of Petitioner-Appellant, supra note 99, at 22-23.

104. Id. Sii 24.

105. Cynthia A. Classman, S.E.C. Comm'r, Statement by SEC Commissioner Regarding

Investment Company Governance, Statement before the Sec. and Exch. Comm'n Open Meeting

(June 23, 2004), http://www.sec.gov/news/speech/spch062304cag.htm [hereinafter Classman

Statement]; Paul S. Atkins, S.E.C. Comm'r, Statement By SEC Commissioner Regarding

Investment Company Governance (June 23, 2004), 2004 WL 1571976, *2 [hereinafter Atkins
Statement]. Prior to the New Rules original compliance date, several funds already had

independent chairs, including Thrivent, One Group, and Goldman Sachs. REPORT IN ACCORDANCE

WITH THE Consolidated Appropriations Act, supra note 4, at * 156-57. In addition, Scudder,

ING, UBS Brinson, and American Century all elected independent chairs prior to the original
compliance date. Id. at *157.

106. Schmidt, supra note 88, at B15.

107. Opening Brief of Petitioner-Appellant, supra note 99, at 24-25.

108. Investment Company Governance, 70 Fed. Reg. 39,390, 39,394 (Sec. and Exch. Comm'n

July 7, 2005) (to be codified at 17 C.F.R. pt. 270) (response to remand).

109. Opening Brief of Petitioner-Appellant, supra note 99, at 30.



1 62 INDIANA LAW REVIEW [Vol. 40: 149

first time around and today's effort is no different. ... It's outrageous that a
regulatory agency would deliberately ignore the orders of a U.S. court of appeals
and disregard calls for a reasoned rulemaking process."' '° Moreover, former

SEC Chairman Harvey L. Pitt originally supported the SEC's adoption of the
New Rules, but since has stated:

If the SEC were evaluating this behavior by the Chairman and two
directors of a publicly-held corporation intent on trampling the rule of

law and the rights of the minority as lame ducks and expiring terms . .

.

its Enforcement Staff would be all over the perpetrators of such conduct,
as it should be, and the agency would be expressing appropriate pieties
about transparency, governance, and protecting the rights of public

investors.'''

On April 7, 2006, the D.C. Circuit vacated the New Rules."^ In Chamber II,
the court first upheld the Chamber of Commerce's standing and ruled that the
SEC's decision to re-adopt the New Rules prior to the court's mandate in
Chamber I was permissible."^ The manner in which the SEC re-adopted the
New Rules after Chamber /, however, was not permissible and violated section
553oftheAPA."^

Although the D.C. Circuit in Chamber I gave the SEC the discretion to
decide whether to take further public comment,"^ the SEC is still obligated under
the APA to abide by the notice and comment requirements, even when re-
adopting a rule."^ The SEC failed to abide by these requirements by relying on
material, specifically a private survey of mutual fund corporate governance and

compensation practices, which was outside the rule-making record."^ In
addition, this new material was the only basis for the SEC's cost estimate when
re-adopting the New Rules, and thus the material was "primary," not just
"supplementary," information."^ The Chamber of Commerce, along with other
interested parties, should have had the opportunity to review, analyze, and

comment on the new information on which the SEC based the re-adoption of the
New Rules. "^

110. SECAgain Adopts Mutual-Fund Governance Rule, U. S. Chamber ofCommerce v. SEC,
Andrews Sec. Litig. & Reg. Rep., July 13, 2005, at 3.

111. Opening Brief of Petitioner-Appellant, supra note 99, at 44 n.9 (quoting Letter from

former Chairman Harvey L. Pitt (June 23, 2005), at 3-4).

1 12. Chamber II, 443 F.3d 890, 909 (D.C. Cir. 2006).

113. Mat 897-99.
114. /^. at 908.

115. Mat 900.
116. Id. at 899. An agency does not need to have additional notice and comment when

additional facts relied on during the re-adoption of a rule merely supplement information in the

rule-making record. Id. at 900.

117. Mat 901-02.
118. Mat 902-03.
119. M. at 904-06.



2007] CORPORATE GOVERNANCE OF MUTUAL FUNDS 1 63

Due to the SEC's failure to allow further notice and comment, the D.C.
Circuit vacated the New Rules; however, since numerous mutual funds have
already come into compliance with the New Rules, the D.C. Circuit is allowing
the SEC to have ninety days in which to reconsider and re-adopt the New
Rules. '^° Although the future actions of the SEC are unclear, especially since the
SEC is now under the new leadership of Chairman Cox,'^' it is imperative that
they reopen the rule-making record for comment if the New Rules are re-
adopted.

^^^

in. The New Rules do not Optimally Achieve the Goals of the SEC

A. The New Regulations Might Not Have Prevented Recent Mutual
Fund Scandals

The SEC designed the newly required independent chair to provide an
additional safeguard against conflicts of interest by vigilantly overseeing fund

management, and thus preventing the illegal transactions that have led to the

recent mutual fund scandals. The New Rules, however, may not have prevented
these scandals. *^^ The "documented abuses" of the recent mutual funds scandals
have not involved transactions covered by the Exemptive Rules. ^^"^ The SEC,
however, believes that the recent mutual fund scandals indicate a "systemic

industry problem[,]" which the New Rules address by increasing the
accountability of the investment adviser to the independent directors and chair,

thus decreasing abusive and illegal practices. ^^^ The SEC, therefore, considers
the New Rules to be "a prophylactic measure, not a response to a present problem
involving abuse of the Exemptive Rules."*^^

Proponents of the New Rules stress that eighty percent of boards involved in
the recent scandals have had inside chairs; however, this statistic is misleading

and does not itself entirely support the independent chair requirement. '^^ This

is because "approximately eighty percent of all fund firms have interested

120. /rf. at909.

121. See Lynn Hume, Judges Side with Chamber: SEC Must Decide on Mutual Fund Rule,

356 The Bond Buyer 1 (2006).
122. Chamber II, 443 F.3d at 909. The D.C. Circuit reasoned that the SEC is the best judge

of whether the New Rules should be re-adopted a second time in order to achieve uniform corporate

governance of mutual funds. Id.

123. See Karmel, Mutual Funds, supra note 2, at 933.

124. Chamber I, 412 F.3d 133, 141 (D.C. Cir. 2005).

1 25. Brieffor CFA Institute as Amici Curiae Supporting Respondents, Chamber ofCommerce
V. Sec. and Exch. Comm'n, 412 F.3d 133 (D.C. Cir. 2005) (No. 04-1300), available at 2005 WL
596760.

126. Chamber I, 4l2F3d at 141.

127. See Investment Company Governance, 69 Fed. Reg. 46,378, 46,391 (Sec. and Exch.

Comm'n Aug. 2, 2004) (Classman and Atkins, dissenting) (to be codified at 17 C.F.R. pt. 270)

(final rule).



164 INDIANA LAW REVIEW [Vol. 40: 149

chairpersons . . . suggest[ing] only that funds with inside chairs are

proportionally implicated in the abusive activity."^^^ Because the SEC did not
sample mutual funds with independent chairs and inside chairs at the same rate,

and the SEC created the enforcement data,'^^ the statistics regarding the
percentage of inside chairs involved in mutual fund scandals is questionable. By
maintaining an inside chair, as opposed to an independent chair, the chair is more
likely to be aware of abusive, illegal, or other harmful activities within the

management company due to his access to information and the management
arrangement.'^^ This gives an inside chair a better opportunity to inform the

board of abusive or illegal practices, allowing the board to take corrective

action.'^'

The New Rules also may not prevent future mutual fund scandals because
many of the illegal and abusive transactions have involved mutual funds working
with entities that are not subject to the Exemptive Rules. '^^ Many of these recent
mutual fund scandals have involved hedge funds advisers that have participated

in the late trading and market timing of mutual funds. '^^ The hedge fund advisers
have been able to exploit mutual fund shareholders by agreeing with mutual fund

advisers to overlook prohibitions on market timing in order for the investment

adviser to receive what has been coined "sticky assets."'^"^ The SEC stated that
almost forty hedge funds and at least eighty-seven hedge fund advisers have been

involved in mutual fund scandals or are currently under investigation in

connection with these scandals.
'^^

One of the most publicized mutual fund scandals involved the hedge fund
Canary Capital Partners and its investment adviser Canary Investment

Management, LLC (collectively "Canary"). '^^ By working with numerous
mutual funds, Canary was able to partake in late trading and market timing,

resulting in Canary receiving tens ofmillions of dollars, fund managers receiving

128. Id. ; Initial Opening Brief of Petitioner, supra note 54, at 9 n. 14.

1 29. Initial Opening Brief of Petitioner, supra note 54, at 9 n. 14.

130. Investment Company Governance, 69 Fed. Reg. at 46,391 (Glassman and Atkins,

dissenting) (final rule).

131. Id. The dissenting commissioners explained that "[a] common feature ofthese [scandals]

is that boards were not told of the formal or informal arrangements permitting market timing." Id.

132. See Chamber /, 412 F.3d 133, 140-41 (D.C. Cir. 2005); Reply Brief of Petitioner at 7,

Chamber of Commerce v. Sec. and Exch. Comm'n, 412 F.3d 133 (D.C. Cir. 2005) (No. 04-1300).

133. Registration Under the Advisers Act of Certain Hedge Fund Advisers, 69 Fed. Reg.

72,054, 72,056 (Sec. and Exch. Comm'n Dec. 10, 2004) (to be codified at 17 C.F.R. pts. 275 and

279).

1 34. Id. at 72,056-57. "Sticky assets" occur when hedge fund advisers deposit assets into other

funds managed by a mutual fiind adviser. Id. at 72,057. REPORT m Accordance with the
Consolidated Appropriations Act, supra note 4, at *73.

135. Registration Under the Advisers Act of Certain Hedge Fund Advisers, 69 Fed. Reg. at

72,057.

136. Registration Under the Advisers Act of Certain Hedge Fund Advisers, Investment

Advisers Act of 1940 Release No. 2266, 2004 WL 1636422, *5-6 (proposed July 20, 2004).



2007] CORPORATE GOVERNANCE OF MUTUAL FUNDS 165

substantial management fees, and mutual fund shareholders losing millions of
dollars. '^^ One such arrangement occurred between Canary and three
subsidiaries of Federated Investors, one of America's largest mutual fund

managers. '^^ In only six months, Canary had $1.6 billion in market timing

transactions with Federated Funds and earned a net profit of over $4.9 million.
'^^

These monetary amounts, however, are small compared to what Canary paid in

a settlement with the New York Attorney General due to its involvement in
numerous mutual fund scandals.'"*^

By intensifying board independence, the SEC brings added scrutiny only to
those transactions covered under the Exemptive Rules,*'*' such as Rule 17a-7,

which allows a mutual fund to conduct securities transactions with other mutual

funds that have common officers, directors, or investment advisers, with approval
of a majority of the independent directors.''*^ Although hedge funds like Canary

could not have conducted these abusive and illegal activities without the aid of

mutual fund directors and advisers, the added scrutiny brought by the

independent directors may not prevent future abuses involving the corroboration
of mutual funds and hedge funds until the SEC begins to stringently regulate and
monitor hedge funds. '"^^ This is because hedge fund advisers, until recently, have

not been required to register with the SEC, and thus, the SEC has not been able
to review their trading activities with respect to mutual funds.*'*'*

B. Current Regulations Under the Investment Company Act Amply Protect
Investors and Address the Issues Raised by the Majority Commissioners

In 2001, less than two years prior to adopting the New Rules, the SEC
required that a board of directors consist of a majority of independent

137. Id.

138. In re Federated Inv. Mgmt. Co., Federated Sec. Corp. and Federated S'holder Serv. Co.,

Investment Advisers Act of 1940 Release No. 2448, Investment Company Act of 1940 Release No.

27,167 (Nov. 28, 2005), at *5.

139. Id. Canary also entered into abusive or illegal transactions with Invesco, PIMCO,

Alliance Capital, and subsidiaries of Bank of America, FleetBoston, Financial Corporation and

Banc One. Report in Accordance with the Consolidated Appropriations Act, supra note

4, at *68.

140. Hurst, supra note 18, at 135. "Canary and its managers agree[d] to make restitution of

$30 million to the [mutual] funds involved and also to pay a $10 million penalty." Id.

141

.

Reply Brief of Petitioner, supra note 1 32, at 8.

142. 17C.F.R. §270.17a-7(2005).

143. The SEC recently passed rules requiring that investment advisers of hedge funds register

with the SEC under the Investment Advisers Act. Registration Under the Advisers Act of Certain

Hedge Fund Advisers, 69 Fed. Reg. 72,054, 72,054 (Sec. and Exch. Comm'n Dec. 10, 2004) (to

be codified at 17 C.F.R. pts. 275 and 279). All hedge fiind investment advisers were required to

register by February 1, 2006. Id.

144. Registration Under the Advisers Act of Certain Hedge Fund Advisers, Investment

Advisers Act of 1940 Release No. 2266, 2004 WL 1636422, *38 n.44 (proposed July 20, 2004).



166 INDIANA LAW REVIEW [Vol. 40: 149

directors.'"*^ When adopting this requirement, the SEC stated that a majority of
independent directors is able to "permit, under state law, the independent

directors to control the fund's 'corporate machinery' i.e., to elect officers of the

fund, call meetings, solicit proxies, and take other actions without the consent of

the adviser" and have a "more meaningful influence on fund management and
represent shareholders from a position of strength."^"^^ Moreover, a majority of

the independent directors has to approve all underwriting and advisory

contracts,
^"^^ allowing the independent directors to have control ofone of the most

important tasks that the board is statutorily required to undertake.
'"^^

1 . A Majority or Super-Majority ofIndependent Directors CouldRequire an
Independent Chair.—Under the 2001 amendments, a majority of independent
directors could require an independent chair if they felt this would best protect

the interest of the shareholders.'"^^ The proposed requirement of a mandatory
independent chair, however, undermines the independent directors' authority to

elect a chair of their choice'^^ by imposing a "regulatory fiat."'^' Opponents of

the New Rules stated that if the SEC succeeds in passing the super-majority
requirement, the independent chair requirement is even more unnecessary

because a super-majority of independent directors can undoubtedly elect an

independent chair. '^^ Moreover, a super-majority of independent directors can

"determine the outcome of any matter put to a board vote and can effectively

control all aspects of the board process, including the scheduling and duration of

meetings, [and] the flow of information prior to and during board meetings."
'^^

The SEC, however, believes that even with a super-majority of independent

145. 15 U.S.C. § 80a-10 (2000); Investment Company Governance, 69 Fed. Reg. 46,378,

46,390 (Sec. and Exch. Comm'n Aug. 2, 2004) (Glassman and Atkins, dissenting) (to be codified

at 17 C.F.R. pt. 270).

146. Id. at 46,391 (quoting the 2001 Adopting Release) (Glassman and Atkins, dissenting).

147. Id. at 46,390 (Glassman and Atkins, dissenting).

148. See id.

149. /J. at 46,391 (Glassman and Atkins, dissenting).

1 50. Letter from Stuart H. Coleman, Chair Comm. on Inv. Mgmt. Regulation, Ass'n ofthe Bar

of the City of New York, to Jonathan G. Katz, Sec'y, Sec. and Exch. Comm'n * 3 (Mar. 9, 2004),

2004 WL 3388074; Investment Company Governance, 69 Fed. Reg. at 46,391 n.26 (explaining that
what works well for one mutual fund board may not be the best choice for another, and in some

cases the board of directors may want to choose an independent chair).

151. Glassman Statement, 5Mpra note 105, at *2.

152. Letter from Eric D. Roiter, Senior Vice President and Gen. Counsel, Fidelity Mgmt. and

Research Co., to Jonathan G. Katz, Secretary, U.S. Sec. and Exch. Comm'n (Mar. 10, 2004),

http://www.sec.gov/rules/proposed/s70304/fidelity031804.htm [hereinafter Roiter Letter]; see

Harold S. Bloomenthal, Investment Companies and Investment Advisers (pt. 1), in 1 Sec. Law

Handbook § 20: 1 . 10 (2006).

153. Roiter Letter, supra note 152. The SEC's Director of the Division of Investment

Management, Paul Roye, testified before the House Financial Services Subcommittee on Capital

Markets that he did not back the independent chair requirement because it deprived the directors

of the ability to make a business judgment that was in the best interest of the shareholders. Id.



2007] CORPORATE GOVERNANCE OF MUTUAL FUNDS 1 67

directors, the board may "not feel sufficiently empowered" to override the
powerful objections of the management company by electing an independent
chair.

'^"^

Regardless of whether a majority or super-majority of independent directors

is required, by not allowing the board to elect or nominate a chairman of their
choice, the new regulations vest less power in the independent directors than they
formerly had, and prevents them from making decisions that they believe are in
the best interest of the shareholders/^^ The Majority Commissioners, however,
explained that the independent directors are not usurped of their power because
they can still choose "the most qualified and capable candidate"; however, this

candidate "cannot serve two masters." *^^

2. Affiliated Directors Bring Expertise to the Board ofDirectors.—A super-
majority of independent directors is not only unnecessary, but it can harm a
mutual fund.^^^ A board of directors should be able to work cooperatively and
as a team; therefore, a mix of both independent and affiliated directors is
required. ^^^ An affiliated chair or director brings the expertise of the
management company to the board meetings that an independent chair or director
does not have, or could only have with detailed study of the management
company. '^^ On the other hand, independent directors may have valuable outside
experience and knowledge from their work in business, government, or
academia.'^^

In studies evaluating the role of sub-committees within a corporation' s board

of directors, *^^ independent directors have been shown to be essential to the audit
and executive compensation committees in order to monitor conflicts of

interests.
^^^ Inside and affiliated directors, however, increase firm performance

1 54. Report in Accordance withthe Consolidated Appropriations Act, supra note 4,

at *144. This is even more true when the mutual fund's investment adviser sponsored or initially

organized the mutual fund. Id.

155. See Initial Opening Brief of Petitioner, supra note 54, at 9, 23.

156. Id. (quoting Investment Company Governance, 69 Fed. Reg. 46,378, 46,381 (Sec. and

Exch. Comm'n Aug. 2, 2004) (to be codified at 17 C.F.R. pt. 270) (final rule)).

157. See Donald C. Langevoort, The Human Nature ofCorporate Boards: Law, Norms, and

the Unintended Consequences ofIndependence and Accountability, 89 GEO. L.J. 797, 798 (2001).

158. Id. at 799. Langevoort, however, does recognize the inherent conflicts of interest in

mutual funds and the need for independent directors to provide a check on "managerial

overreaching." Id. at 814.

159. Investment Company Governance, 69 Fed. Reg. 3472, 3475 n.31 (Sec. and Exch.

Comm'n proposed Jan. 23, 2004) (to be codified at 17 C.F.R. pt. 270); see also Initial Opening

Brief of Petitioner, supra note 54, at 9.

160. Investment Company Governance, 69 Fed. Reg. at 46,392 n.35 (Glassman and Atkins,

dissenting) (final rule).

161. See April Klein, Firm Performance and Board Committee Structure, 41 J.L. & ECON.
275,279(1998).

162. Id. at 279. In order to monitor conflict of interests, the auditing committees of investment

companies must nominate an independent auditor, and the independent directors must ratify the



168 INDIANA LAW REVIEW [Vol. 40: 149

when placed on the finance and long-term investment committees due to their
specialized expertise. '^^ This again suggests that a board of directors that is

composed ofboth independent and affiliated directors is in the best interest of the
shareholder^^ because it monitors conflicts of interest while simultaneously

bringing the expertise of the management company and mutual fund industry.
Some supporters ofthe New Rules, however, argue that an independent chair

has enough expertise to lead the board effectively.'^^ In addition, even if
expertise is lacking, the independent chair can rely on other inside directors or
personnel of the management company for information.'^^

Affiliated directors bring tactical decision-making and long term strategic

planning to the board. '^^ In addition, they also bring personal motivation to a

board since their financial wealth and capital and professional reputation are

linked to the success and integrity of the mutual fund.'^^ This desire for a

successful and profitable fund is motivation for directors, both affiliated and

independent, to reduce fund advisory fees while compelling integrity and fair

dealing within the management company. '^^

3. The New Rules Disregard Market Forces that Influence Investors.—The
independent chair and the seventy-five percent independent board requirements

disregard market forces that influence investors. Investors often choose a fund

based upon the expertise and accomplishments of the mutual fund's adviser and
management, not the board of directors. '^° Moreover, investors are also
influenced by prior illegal and abusive activities and choose funds that operate

legally and in the best interest of the shareholders.'^' It is not difficult for

nomination. Standards Related to Listed Company Audit Committees, Securities Act Release No.

8220, Exchange Act Release No. 47,654, 68 Fed. Reg. 18,788 (Apr. 16, 2003) (codified at 17

C.F.R. pts. 228-29, 240, 249, 274 (2004)).

163. Klein, supra note 161, at 277-78; see also Sanjai Bhagat & Bernard Black, The Non-
Correlation Between Board Independence and Long-Term Firm Performance, 27 J. CORP. L. 23 1,

264(2002).

164. See Langevoort, supra note 157, at 799.

1 65

.

Report in Accordance with the Consoudated Appropriations Act, supra note 4,

at * 140-45. For example, the American Century (Mountain View) board elected a knowledgeable

independent director. Professor Ronald Gilson, who had previously served for ten years as an

independent director and is a professor ofbusiness law at Columbia Law School and Stanford Law

School. Id. at *142.

166. Mat*141.

167. See Bhagat & Black, supra note 163, at 264; Langevoort, supra note 157, at 806.
168. See Bhagat & Black, supra note 162, at 265; Langevoort, supra note 157, at 806.
169. Investment Company Governance, 69 Fed. Reg. 46,378, 46,392 (Sec. and Exch. Comm'n

Aug. 2, 2004) (Classman and Atkins, dissenting) (to be codified at 17 C.F.R. pt. 270) (final rule).

170. Investment Company Governance 69 Fed. Reg. 3472, 3473 (Sec, and Exch. Comm'n

proposed Jan. 23, 2004) (to be codified at 17 C.F.R. pt. 270).

171. Atkins Statement, supra note 105, at *2. For example, in 2003, shareholders pulled $29

billion out of Putnam Investment Management after the SEC revealed abusive and illegal activity.

James Glassman, Fund Follies, AMERICAN ENTERPRISE INSTITUTE FOR PUB. POL'Y RES., May 24,



2007] CORPORATE GOVERNANCE OF MUTUAL FUNDS 1 69

disgruntled shareholders of mutual funds to redeem their shares, thereby leaving
the investment advisers and management company with fewer assets to
manage. '^^ In addition, Commissioner Classman has stated that "many of the
top-rated funds today based on high-performance and low fees have inside

chairs," and it is therefore not fair for the SEC to tell shareholders "they can no
longer have the form of governance that produced this high level of

performance[.]'"^^ By dictating the structure of the board of directors, the New
Rules ignore the market forces that influence the investors to invest in a specific

mutual fund.*^"^

4. The New Rules Do Not Focus on the Investment Adviser*s Fiduciary
Duty.—The New Rules de-emphasize the fiduciary obligations of the investment
adviser by putting the responsibility of the adviser* s actions on the board of

directors. '^^ Although the board of directors needs to monitor and thwart

conflicts of interest, the investment adviser, as a fiduciary of the shareholders,

has the ultimate responsibility to protect the shareholders' investments.'^^

Considering that the recent mutual fund scandals have almost all involved a

breach of the investment adviser's fiduciary duty, the New Rules do not place the
proper emphasis on this important legal safeguard.

'^^

The SEC's suit against Invesco Funds Group, the investment adviser of the
Invesco complex of mutual funds, demonstrates a breach of fiduciary duty.'^^
Invesco Funds Group and its CEO allegedly accepted investments from certain
investors and, in exchange, permitted the investors to partake in market timing

transactions in order to increase the management fees.'^^ This market timing was
prohibited by the mutual fund's disclosure statements and was injurious to long-
term shareholders.'^® By allegedly permitting the market timing transactions and
the conflict of interest caused by the increased management fees, Invesco Funds

2004, http://www.aei.org/publications/pubID.20609,filter.all/pub_detail.asp. In addition, Putnam,

Janus, and Amvescap, all fund families involved in mutual fund scandals, lost a total of $52 billion

in assets in 2003, while the rest of the mutual fund industry experienced significant gains. Id.

172. See Mark J. Roe, Political Elements in the Creation ofa Mutual Fund Industry, 139 U.

Pa. L. Rev. 1469, 1505-06 (1991) (explaining that it is much easier for a mutual fund shareholder

to deal with conflicts of interest than a shareholder in a corporation attempting to deal with conflicts

of interest involving corporate managers).

173. Glassman Statement, supra note 105, at 2.

174. Investment Company Governance, 69 Fed. Reg. at 46,392 (Glassman and Atkins,

dissenting) (final rule).

175. Atkins Statement, supra note 105, at *3.

176. Id.\ see Burks v. Lasker, 441 U.S. 471, 481 n.lO (1979).

177. Atkins Statement, supra note 105, at *3. The New Rules only mention the adviser's

fiduciary duties in a footnote. Id. See Hurst, supra note 18, at 154 (suggesting that an investment

adviser's fiduciary duty should be strengthened in order to increase investor protection).

178. Sec. and Exch. Comm'n v. Invesco Funds Group, Inc., Litigation Release No. 18482, 8

1

SEC Docket 2397, *1 (Dec. 2, 2003).

179. Id.

180. /^. at*l-2.



170 INDIANA LAW REVffiW [Vol. 40:149

Group breached its fiduciary duty to act in the bests interests of the
shareholders/^' This included the duty to act with the utmost good faith and to
give full and fair disclosure of all material facts to the investors. '^^ The
independent directors of the Invesco complex ofmutual funds did not fulfill their

role as "independent watchdogs" due to their failure to monitor the mutual fund'

s

management and prevent transactions that were detrimental to the
shareholders.'^^ Nevertheless, this does not excuse the investment adviser and

the management company for breaching their fiduciary duties to shareholders.

C The SEC Has Not Methodically Reviewed Prior Mutual Fund Regulations
nor Is There Sufficient Empirical Evidence on Which to Base

the New Regulations

The SEC has made no effort to thoroughly and methodically review existing
corporate structure regulations, in the context of both corporations and

investment companies, in over twenty years. '^"^ During the two-year interim,

between the 2001 amendments and the New Rules, the SEC continued this trend
by not examining the effect of the 2001 amendments to determine if the majority
of independent directors had gained the desired control over the board of

directors and the investment advisers.
'^^

In addition, the SEC has not reviewed the fund performance and compliance
record ofthose funds that already have an independent chair compared with those

that have an affiliated chair. '^^ In response to the SEC's expressed interest in
consulting empirical data regarding independent versus affiliated chairs. Fidelity

conducted a study, commonly called the Bobroff Mack Report (the "Report"),
which indicates that there is a negative correlation between independently

chaired funds and overall fund performance.'^^ In addition, there is also no

181. Id.'dt*2.

182. Id.

183. See Burks v. Lasker, 441 U.S. 471, 482-84 (1979).

1 84. Joel Seligman, A Modest Revolution in Corporate Governance, 80 NOTREDAMEL. REV.

1159,1185(2005).

1 85. Investment Company Governance, 69 Fed. Reg. 46,378, 46,39 1 (Sec. and Exch. Comm'n

Aug. 2, 2004) (Glassman and Atkins, dissenting) (to be codified at 17 C.F.R. pt. 270) (final rule).

1 86. Chamber II, 443 F.3d 890, 905 (D.C. Cir. 2006); Karmel, Key Outcomes, supra note 15,

at *5. The SEC stated that the data they do have relating to the correlation between fund

performance and an independent chair is inconclusive. REPORT IN ACCORDANCE with THE

Consolidated Appropriations Act, supra note 4, at *5.

187. Geoffrey H. Bobroff & Thomas H. Mack, Assessing the Significance ofMutual Fund
BoardIndependent Chairs, A Study For Fidelity Investments (Mar. 10, 2004), http://www.sec.gov/

rules/proposed/s70304/fidelity03 1804.htm [hereinafter Bobroff Mack Report]. "Using

Morningstar's fund rankings . . . independent chair fiinds on average rank in the 53rd percentile

(100 = best) over the past three years, while management chair funds on average rank in the 58th

percentile." Id. This statistical variation is even more pronounced when examining fund

performance over the past ten years. Id. Other corporate studies, however, show that there is no



2007] CORPORATE GOVERNANCE OF MUTUAL FUNDS 171

correlation between independently chaired funds and lower expensesJ ^^ The
Chamber of Commerce believes that the SEC should have given more
consideration and weight to the Report.

*^^

Reliable and valid empirical studies of the relationship between fund

performance and director independence are difficult to create because there are

varying assumptions made about "how performance is measured, which expenses
should be included, what time period should be examined, and which funds

should be examined." ^^^ In addition, a lack of available information and the

multifaceted nature ofthe conflict of interest between a mutual fund' s investment

adviser and shareholders make standard methodologies difficult to use in
establishing empirical evidence.*^' The SEC chose not to use the Report in its
Adopting Release of the New Rules for several reasons. '^^ The SEC stated,
among other things, that the Report does not examine the future impact that the
independent chair requirement will have on fund performance, only the past
performance.*^^ Furthermore, using the same statistics another commentator
found that independently chaired funds performed slightly better than those with

affiliated chairs,
'^"^ with the resulting differences attributed to varying sample

selections and empirical methods. '^^ The SEC also stresses that the purpose of
the New Rules is not to increase fund performance, but rather to increase fund
compliance and decrease transactions that result from a conflict of interest.

*^^

When the Chamber of Commerce brought the issue of the Report and the
need for empirical studies before the D.C. Circuit, the court noted that although

"acting upon the basis of empirical data may more readily be able to show it [the
SEC] has satisfied its obligations under the APA," the empirical data is not
necessary to justify a rule-making action. *^^ Nevertheless, a comprehensive and

correlation between the number of independent directors on a board and firm performance.

Benjamin E. Hermalin & Michael S. Weisbach, Board of Directors As An Endogenously
Determined Institution: A Survey ofThe Economic Literature, FED. RES. BankN.Y. ECON. Pol'

Y

Rev. 8 (Apr. 2003).

188. BobroffMack Report, supra note 1 87. Other studies of investment companies, however,

have found that boards with more independent directors are likely to have lower fees. Hermalin &
Weisbach, supra note 187, at 19.

189. Caroline Bradley, Private International Law-Making for the Financial Markets, 29

FordhamInt'lL.J. 127, 180n.34 (2005).

1 90. Report in Accordance with the Consoudated Appropriations Act, supra note 4,

at *159-60.

191. Mat*165-67.

192. Brief of Respondent at 26, Chamber of Commerce v. SEC and Exch. Comm'n, 412 F.3d

133 (D.C. Cir. 2005) (No. 04-1300).

193. Id.

194. Id.

1 95

.

Report in Accordance with the Consolidated Appropriations Act, supra note 4,

at*182.

196. Id. at *5, 157-58.

197. Chamber I, 412 F.3d 133, 142 (D.C. Cir. 2005); see Ruder, supra note 18, at 48-49.



172 INDIANA LAW REVIEW [Vol. 40: 149

statistically sound empirical study of the correlation between independent chairs

and fund performance would most likely help the SEC in justifying the New
Rules. '^^ This is because halfofmutual fund investors indicate fund performance

as the number one factor in influencing their impression of the mutual fund
industry, while two thirds of investors claim that fund performance is very

important in shaping their impression of the mutual fund industry. '^^ Moreover,

sixty-five percent of investors stated that fund performance is the most important

reason that they own mutual funds.^^

In addition to the SEC's lack of strong empirical evidence linking board and
chair independence to better fund performance, the SEC also lacks empirical
evidence linking board and chair independence to favorable compliance

records.^^^ The SEC stated, however, that this empirical evidence was impossible
to analyze "because there is no clear method for measuring the quality of
compliance by funds and their advisers," especially since "enforcement actions

are only one indication of compliance."^^^ Despite this, the SEC has brought
recorded enforcement actions against mutual funds with the corporate structure

proposed by the New Rules. Among the funds that have independent chairs,
several of them have been involved in enforcement actions involving market-
timing abuses.^^^ This includes Bank of America, Banc One, and Putnam
Investment Management.^^"^ Moreover, in a recent action that the SEC brought
against Banc One, Banc One's board of directors was seventy-five percent
independent at all times while the abusive conduct was taking place.^^-^ In this

action, Banc One was alleged ofhaving committed numerous illegal and abusive
activities that resulted in prohibited conflicts of interests.^^^ This includes,

among other things, market timing transactions with hedge fund advisers, failure
to charge the hedge fund advisers redemption fees, and improper disclosure of

confidential information.^^^ Due to these abusive activities of Banc One, hedge

198. See Ruder, supra note 18, at 51-52.

199. Fundamentals, supra note 14, at 7.

200. Id

201. Karmel, Key Outcomes, supra note 15, at *4.

202. Report in Accordance with the Consolidated Appropriations Act, supra note 4,

at*183.

203

.

Glassman Statement, supra note 1 05 . In addition, "the relative proportion of late trading

and market timing cases by funds with independent chairs was roughly equivalent to their relative

proportion of all mutual funds." Letter from Cynthia A. Glassman and Paul S. Atkins, Comm'rs,

Sec. and Exch. Comm'n, re: StaffReport on the Exemptive Rule Amendments of 2004: The Indep.

Chair Condition, to Thad Cochran, Chairman, Comm. on Appropriations, United States Senate

(Apr. 29, 2005), 2005 SEC Lexis 1032, at *2-3.

204. Atkins Statement, supra note 104, at *3.

205. In re Banc One Investment Advisors Corporation and Mark A. Beeson, Investment

Advisers Act of 1940 Release No. 2254, Investment Company Act of 1940 Release No. 26,490, 83

S.E.C. Docket 695, 84 S.E.C. Docket 2404, at 17 n.3 (June 29, 2004).

206. /fif. atl-3.

207. Id.



2007] CORPORATE GOVERNANCE OF MUTUAL FUNDS 1 73

fund advisers received millions of dollars.*^^^ Independent directors have also

been involved in enforcement actions for failing to meet their legal duties.^^

D. The Disclosure Alternative

The SEC, in their original adoption of the New Rules, failed to consider the
disclosure alternative that the two dissenting commissioners raised, thereby

violating the APA.^*^ The disclosure alternative would require mandatory
disclosure of whether the chair of the board of directors is independent or

affiliated with the management company, therefore allowing investors to choose
a fund based upon their perceived importance of an independent chair.^'^
Although the SEC is not required to analyze every alternative when proposing a
new rule, they are required to analyze those alternatives that are not uncommon
or frivolous.^^^ The SEC originally claimed that they did not need to analyze the
disclosure alternative because Congress rejected a "purely disclosure-based

approach" to the ICA; however, in Chamber /, the D.C. Circuit rejected this
argument since Congress does require extensive disclosure for many matters
relating to investment companies.^

*^

On remand, the SEC reconsidered and rejected the disclosure alternative.^ '"^

They believe that the disclosure of whether the chair was independent would not
adequately protect investors from the inherent conflicts of interest that arise from

the relationship between the shareholders and the investment adviser.^ *^ This is

because disclosure itselfcannot prevent investment advisers and the management
company from putting their own interests ahead of the shareholders by engaging
in self-dealing, abusive, or illegal transactions.^'^ Moreover, disclosure of a

management-affiliated chair would not obtain the benefits that the New Rules are
attempting to seek, such as encouraging open dialogue and increased oversight

208. Mat 1-5.
209. Report in Accordance with the Consolidated Appropriations Act, supra note 4,

at *32 n.44. The SEC implicated independent directors of abusive and illegal activities while

serving on the boards of Parnassus Investments, Rockies Fund, Inc., and Monetta Financial

Services, Inc. Id.

210. Chamber 1, 412 F.3d 133, 145 (D.C. Cir. 2005); see Karmel, Key Outcomes, supra note

15, at *3.

211. Investment Company Governance, 69 Fed. Reg. 46,378, 46,393 (Sec. and Exch. Comm'n

Aug. 2, 2004) (Classman and Atkins, dissenting) (to be codified at 17 C.F.R. pt. 270) (final rule).

212. Chamber I 412 F.3d at 144-45.

213. M at 144 (explaining that the ICA requires mutual funds to make extensive disclosures,
including filing a registration statement with the SEC, sending semiannual reports to investors, and

making all filed documents publicly available); see 15 U.S.C. §§ 80a-8(b) (2000).

214. Investment Company Governance, 70 Fed. Reg. 39,390, 39,396-97 (Sec. and Exch.

Comm'n July 7, 2005) (to be codified at 17 C.F.R. pt. 270) (response to remand).

215. Id.

216. /rf. at 39,397.



1 74 INDIANA LAW REVIEW [Vol. 40: 149

by the board of directors.^
'^

The SEC also rejected the disclosure alternative due to investors' lack of
knowledge about the complex conflicts of interest that are inherent in mutual
funds.^^^ In order to make the disclosure of an independent or management
affiliated chair meaningful, the investor would first have to understand the
significance and impact that the chair can have on board and management
oversight.^ '^ Without this understanding, the investor cannot make the proper
decisions with the disclosed information. Moreover, disclosure to shareholders

by investment advisers about conflicts of interests can increase the shareholders

trust in the management and investment adviser, as opposed to making the
shareholder more skeptical and cautious.^^° This trust could cause the
shareholders to place greater weight on the biased advice.^^' In addition,

excessive disclosure could also have a chilling effect on the entry of new mutual
funds to the industry.^^^

Commissioners Classman and Atkins believe that the SECs reconsideration
of the disclosure alternative was inadequate.^^^ Their statements highlight one
of the many alleged procedural errors demonstrated by the SEC. The SEC
originally did not seek specific comment on the disclosure alternative; thus, there
was sparse public comment to determine if others, including investors and the
mutual funds themselves, believed disclosure to be a viable alternative.

^^"^

Moreover, in Chamber I, the D. C. Circuit told the SEC to use its "expertise" and
"best judgment" to examine the disclosure alternative; however, the SEC asked
neither Commissioners Classman nor Atkins to comment on or analyze the
alternative.^^^ The failure of the Majority Commissioners to ask Commissioners
Classman and Atkins about the merits of the disclosure alternative is ironic since

they originally proposed the alternative.

The disclosure alternative is parallel to the SEC's goal of providing

217. Id.

218. Id.; see Bullard, supra note 3 , at 1 1 48 (asking if "the problem offund disclosure lay with

the complexity offunds themselves"); see Barbara Black & Jill Gross, The Elusive Balance Between
Investor Protection and Wealth Creation, 26 PACE L. Rev. 27, 37 (2005) (explaining that many

investors are ignorant about basic investment decisions, and thus educating investors is one of the

best ways to foster investor protection); see Daylian M. Cain et al.. The Dirt on Coming Clean:

Perverse Effects ofDisclosing Conflicts ofInterest, 34 J. LEGAL STUD. 20-21 (2005).

219. See Investment Company Governance, 70 Fed. Reg. at 39,397 (response to remand).

220. See Cain et al., supra note 218, at 6-7.

221

.

See id. In addition, the requirement of added disclosure can cause investment advisers

to embellish "their advice in order to counteract the diminished weight that they expect

[shareholders] to place on it." See id. at 7. Therefore, the disclosed information is less reliable.

Id.

222. Bullard, supra note 3, at 1 148.

223. See generally Investment Company Governance, 70 Fed. Reg. at 39,390 (Glassman and

Atkins, dissenting) (response to remand).

224. Id. at 39,404 (Glassman, dissenting).

225. Id. at 39,407-08 (Atkins, dissenting).



2007] CORPORATE GOVERNANCE OF MUTUAL FUNDS 175

transparent markets in order to increase investor protection in the securities

arena.^^^ Even if the SEC ultimately deems the disclosure alternative to be
insufficient due to lack of investor knowledge or the psychological effects that
disclosure can have on investors and advisers, the SEC should only make this
judgment after serious analysis and consideration. This is because one of the

purposes of all the securities statutes, including the Divestment Advisers Act, the

Securities Act of 1933, the Securities Exchange Act of 1934, and the ICA, is full
disclosure in order to obtain ethical business practices within the securities

industry.^^^

Conclusion

The SEC's New Rules attempt to prevent future mutual fund scandals and
increase investor protection and confidence by enhancing the integrity and

honesty of the mutual fund industry. Within the past few years, numerous
scandals have revealed directors, management companies, and investment
advisers engaging in abusive and illegal transactions that adversely affect the

interest of shareholders. Although it is imperative that the SEC takes action to
correct these wrongdoings and instill an improved sense of trust in investors due

to the continued growth of the industry, the adoption of the New Rules may not
be the best course of action for the SEC.

The long-term effects of a majority of independent directors are not yet
known, and there is a lack of reliable empirical evidence regarding the

relationship of board independence and fund performance and compliance.

Therefore, it is difficult to tell the impact that a super-majority of independent

directors along with an independent chair will have on the oversight of the

management company and the protection of investors. Although, the
independent directors may be in a better position to promote an open and honest
dialogue within the boardroom, the cost to shareholders may be significant and
detrimental. This includes not only monetary costs, but also non-monetary costs,

such as the loss ofexpertise, the de-emphasis ofmarket forces and the investment

adviser's fiduciary duty, and the lack of choice independent directors will have

when nominating a new chair. Furthermore, other recently adopted SEC rules,
such as requiring mutual funds to obtain a chief compliance officer^^^ and the

registration of hedge funds,^^^ may provide some of the necessary safeguards to

226. Registration Under the Advisers Act of Certain Hedge Fund Advisers, 69 Fed. Reg.

72,054, 72,059 (Sec. and Exch. Comm'n Dec. 10, 2004) (to be codified at 17 C.F.R. pts. 275 and

279).

227. Sec. and Exch. Comm'n v. Capital Gains Research Bureau, Inc., 375 U.S. 180, 186

(1963).

228. See Compliance Programs of Investment Companies and Investment Advisers, 68 Fed.

Reg. 74,714, 74,721 (Sec. and Exch. Comm'n Dec. 24, 2004) (to be codified at 17 C.F.R. pts. 270,

275, 279).

229. See Registration Under the Advisers Act of Certain Hedge Fund Advisers, 69 Fed. Reg.

at 72,054.



176 INDIANA LAW REVIEW [Vol. 40: 149

prevent future illegal and abusive behavior.

The Chamber of Commerce's lawsuits against the SEC challenged both
procedural and substantive aspects of the New Rules. Although the future of the
New Rules is uncertain due to the D.C. Circuit's second remand, the court made
it clear that the SEC has the power to re-adopt the New Rules a third time if the
SEC takes the proper procedural steps, including further public comment.^^^
Therefore, regardless of whether the SEC re-adopts or vacates the New Rules, it
should comprehensively study the arguments for and against board independence

since it is an issue that will continue to loom overhead.^^'
Although the Chamber of Commerce's lawsuit against the SEC may not

result in the ultimate abandonment of the New Rules, it has given the SEC and
other regulatory agencies greater knowledge of the proper procedural processes

to be followed when engaging in rule-making. In addition, the SEC is now aware
of the public, political, and legal backlash caused by a rushed re-adoption of

regulations not based on empirical studies or public comment. Unless the SEC
abandons the New Rules, both critics and supporters will be watching and
waiting to see if the SEC strikes out for a third time with the D.C. Circuit.

230. See Chamber II, 443 F.3d 890, 909 (D.C. Cir. 2006).

231. Id. at 904.