Eyeing new investment fund rules: new SEC-driven rules react to market-timing and late trading practices, aiming to correct governance policies and address deficiencies.

Financial executives are again finding themselves readjusting to new Securities and Exchange Commission (SEC) rules--this time related to major changes in the way institutional investors govern both themselves and the companies in which they invest. Though some of these changes have been in response to the scandals in the mutual fund and annuities industries, others have attempted to address suspected longer-term deficiencies in the financial system.

Financial Executives Research Foundation (FERF) reviews the changes with an eye towards the implications for finance professionals, and SEC Commissioner Cynthia Glassman comments on some of the new rules.

In January 2003, the SEC ruled that all investment companies and investment advisors must formulate and disclose a set of policies and procedures they will use in deciding how to vote on proxy votes for the equities they own. Beginning in August 2004, these companies were required to publish their actual votes for the past 12 months.

In "Analysis and Implications of the New Proxy Voting Rules for Mutual Funds, "FERF examined the new proxy policy statements for the 10 largest mutual funds families and found they all had a large degree of similarity. Key points common to most of them include:

* The proxy voting decision is normally made by a proxy voting group at the fund management company, rather than by the fund itself.

* Likewise, the fund families will vote the proxies in all their funds as a block. Vanguard, for example, decides on a Vanguard-wide position on a proxy issue and has all its funds vote that way.

* All fund families are opposed to anti-takeover measures, such as poison pills, dual-class stock, supermajority voting and staggered boards. They are strongly in favor of boards with a majority of independent directors, with special emphasis on the audit, compensation and nominating committees.

* The fund families are not in favor of limits on executive compensation. They are, however, against certain types of compensation they consider unfair, such as awarding stock options with below-market strike prices, re-pricing underwater options and any option plan that dilutes existing equity by more than about 2 percent per year.

* The funds are willing to give management wide leeway on all operational issues. This includes important financial decisions such as new loans or equity.

* The funds made it clear they will not be voting with activists on certain social/ethical issues.

* Almost all funds use an independent proxy voting service such as Institutional Shareholders Services (ISS). Some funds use these services simply as advisors; some use them to handle the mechanics of voting, while others follow their voting recommendations to the letter.

Living the Rules

SEC Commissioner Glassman, in commenting on how the rules were working out, pointed out that there is an inherent tension between the goal of greater participation in corporate governance by institutional owners and the goals of Regulation Fair Disclosure (Reg FD).

For example, suppose a large institution and shareholder of a company requests a meeting with the CEO or CFO to discuss company business, how is a company to react? Suppose a CEO wants to discuss a proposed compensation package with the major fund owners prior to submission. Is this material non-public information? If so, is it "reasonably foreseeable" that the institution will trade the company's shares based on this information? In this circumstance, is Reg FD implicated?

The FERF study also found that some of the funds outsource their proxy voting decisions to specialist firms such as ISS, which gives additional control to these outsourcing firms.

Glassman says that the introduction of outsourcing firms affects the proxy decision-making process, adding more and more intermediate steps. "When you think about the purpose of shareholder voting, the board represents shareholders [for] publicly held [companies]," she notes. "When the underlying shareholders invest indirectly through funds, their voting decisions are one step removed. If the funds, in turn, outsource their proxy voting decisions to third parties, the decision-making moves further away from the underlying shareholders. Who's to say whether or not the shareholder interests are being represented?"

Governance within mutual funds is another area in which the SEC is making major changes. Traditionally mutual funds were pretty much run by their organizing company. The funds are required to have boards of trustees, but, in practice, these boards exercised little power. It was unheard of, for example, for a Putnam fund board to change managers to, say, a Fidelity manager.

The recently SEC-promulgated rule that requires the chairman of a fund's board to be independent of the managing company clearly increases the power of the trustees at the expense of the managing company.

According to the Investment Company Governance rule, "to be truly effective, a fund board must be an independent force in fund affairs rather than a passive affiliate of management. Its independent directors must bring to the boardroom 'a high degree of rigor and skeptical objectivity to the evaluation of management and its plans and proposals,' particularly when evaluating conflicts of interest ... the paramount principle that must prevail, and should animate all decisions directors are called upon to make, is that a fund must be managed on behalf of its investors rather than on behalf of the adviser or other affiliated persons of the fund."

Conceptually, this would appear to be good for investors, possibly because the boards would not have the potential conflicts of interest that the fund management companies might. (For example, a fund management company that owns shares in Company X might also be managing the 401(k) accounts of that same company.)

Glassman and Commissioner Paul S. Atkins dissented on this issue. In a written dissent, they jointly stated: "We support the rulemaking's commendable objective of strengthening investor protection for fund shareholders. However, we fear that the path chosen to achieve this objective may lead in the opposite direction--at a substantial cost to fund shareholders."

She notes that in adopting the rule, no meaningful cost-benefit analysis was undertaken to substantiate it. In the absence of empirical evidence, she believes that the significant costs that a majority of funds will incur in order to obtain independent chairmen is not justified. Glassman also says that an investor buying a mutual fund is likely buying the brand of the fund management company.

Targeting Hedge Funds, Shareholder Proxy Access

The hedge fund industry is still another target for the SEC. This industry has grown enormously in the past decade, by some estimates accounting for over half of U.S. equity volume. Hedge funds, by law, must market only to presumably sophisticated individuals or institutional investors. For that reason, hedge funds have not been subject to specific SEC oversight, although they must obey all applicable securities laws.

Although hedge fund investments still total less than 1 percent of investments in pension funds, hedge funds have become a larger percentage when compared to the past, and have recently been involved in enforcement actions and late-trading mutual fund scandals.

Accordingly, in order to "provide the protections afforded to investors in hedge funds," the SEC has proposed to require all funds over a certain size that market to U.S. investors to register with the SEC. Although procedurally unusual, Glassman and Atkins issued a written dissent to this proposed rule. Noting that a recent staff study found no evidence of hedge fund "retailization" or an increase in fraud, Glassman urged the SEC to undertake a more robust study to identify specific problems with hedge funds before proposing regulation.

Arguably, one of the most hotly-debated SEC proposal concerns shareholder access to the company proxy. The proposed rule the SEC is considering would, under certain circumstances "require companies to include in their proxy materials security holder nominees for election as director."

One such circumstance, or "trigger," proposed by the SEC states that if at least one of the company's nominees for director receives "withhold" votes from more than 35 percent of the votes cast at an annual meeting, the shareholders would be able to nominate a certain number of directors (anywhere from one to three, depending upon the then-current size of the board) at the next annual meeting.

The SEC has received an understandably large number of comments on the proposed rule (16,000, including form letters), and it continues to review the proposal. Any final rule adoption will require agreement by at least three of the five commissioners. By press time, no decision had been made.

Bottom line, what do all these new and proposed rules mean to financial executives? On most day-to-day corporate business issues, the funds will continue to allow management to make its own decisions on capital structure or choice of auditors. However, the funds are unwilling to support management-dominated boards or voting that dilutes shareholder control. If this leads to an increase in hostile M & A activity, financial executives need to be prepared and consider the perspective of the major funds before deciding on new initiatives.

Items on the SEC Agenda

Rule                                         Status
Disclosure of Proxy Voting Policies Records  Final Rule
www.sec.gov/rules/final/33-8188.htm
Description: Require registered management investment companies to
provide disclosure about how they vote proxies relating to portfolio
securities they hold. Registered management investment companies must
file with the Commission and make available to shareholders the specific
proxy votes cast in shareholder meetings.
Effective date: Disclosure of proxy procedures and policies were
required in January 2003. Publication of actual proxy votes was
effective August 2004.

Rule                                         Status
Investment Company Governance                Final Rule
www.sec.gov/rules/final/ic-26520.htm
Description: Requires investment companies to adopt certain governance
practices.
The rule requires that:
* At least 75 percent of the fund directors be independent or, if the
fund board has only three directors, all but one of the directors must
be independent.
* The chairman of the board must be independent.
* Fund directors evaluate, at least once annually, the performance of
the fund board and its committees.
* Independent directors meet at least once quarterly in a separate
session at which no directors who are interested persons of the fund are
present.
Effective date: Sept. 7, 2004, with a compliance date of Jan. 16, 2006.

Rule                                         Status
Registration of Hedge Fund Advisers          Proposed Rule
www.sec.gov/rules/proposed/ia-2266.htm
Description: The proposed new rule would require hedge fund advisers to
register with SEC.
Comments should be received on or before Sept. 15, 2004.

Rule                                         Status
Security Holder Director Nominations         Proposed Rule
www.sec.gov/rules/proposed/34-48626.htm
Description: Requires companies to include in their proxy materials
security holder nominees for election as director. Proposed rules would:
* Create a mechanism for nominees of long-term security holders with
significant holdings to be included in company proxy materials.
* Apply in instances where evidence suggests that the company has been
unresponsive to security holder concerns related to the proxy process.
* Enable security holders to engage in limited solicitations to form
nominating security holder groups and engage in solicitations in support
of their nominees without disseminating a proxy statement.
* Establish the filing requirements under the Securities Exchange Act of
1934 for nominating security holders.
Additional information is available under "Spotlight on Security Holder
Director Nominations" on the SEC Web site (www.sec.gov).

Burton Rothberg ([e-mail]) is Assistant Professor at the Bicklin School of Business of Baruch College, City University of New York. Cheryl de Mesa Graziano, CPA ([e-mail]), is Director of Research for Financial Executives Research Foundation (FERF).