ICI Comments on SEC Staff Economic Papers Relating to Fund Governance

Washington, DC, March 2, 2007 - Two studies prepared by the SEC's Office of Economic Analysis (OEA) provide no compelling evidence that mutual fund board independence requirements are necessary or that they would provide any benefits that would justify their attendant costs, according to an ICI comment letter and report.

Background
Late in 2006, the SEC reopened the comment period on rule amendments requiring that funds relying on certain exemptive rules under the Investment Company Act of 1940 have an independent chair and a board with no less than 75 percent independent directors. The Commission did so to permit public comment on two studies prepared by its Office of Economic Analysis (OEA) relating to mutual fund board independence. Originally adopted by the SEC in July 2004, the rule amendments require mutual funds relying on certain exemptive rules to have a board with at least 75 percent independent directors and an independent chair.

ICI Position
The Institute filed a comment letter with the SEC, along with a paper analyzing and commenting on the OEA studies. In the letter the Institute concludes that the SEC's studies provide no basis for mandating that virtually all fund boards have an independent chair or for raising the required percentage of independent directors to 75 percent. The letter ultimately recommends that the SEC conclude this rulemaking proceeding without further action.

The paper discusses the two OEA studies within the framework that regulators generally use when analyzing the economic rationale of a rule. The framework involves first identifying the need for a rule (in economic terms, the market imperfection or market failure that the rule seeks to address), then identifying the benefits associated with the rule, and finally, weighing those benefits against the costs of the rule.

Market Imperfections
The paper discusses the three main groups of market imperfections that the OEA's Literature Review examines, all of which involve potential conflicts between the interests of fund advisers and those of fund shareholders. The paper points out that it is not clear that these putative conflicts are always economically meaningful, work to the detriment of fund shareholders, or fail to be addressed by existing SEC rules or mitigated by market forces.

The paper notes that if these conflicts do have a meaningful influence on advisers' behavior that is not addressed by current rules and market forces, it remains unclear how requiring an independent chair or 75 percent independent board would address them.

Market Forces Helping Align the Interests of Advisers and Investors
The paper also discusses more generally how market forces help to align the interests of fund advisers and investors. The paper expresses the Institute's belief that the Literature Review understates the extent to which market forces spur competition in the fund industry. It argues that it is less costly for investors to search among funds, and that shareholders are more willing and able to move among funds, than the Literature Review suggests. The paper emphasizes the competitive pressures that result from the strong demand between fund shareholders for low-cost funds, and also discusses academic research suggesting that a fund adviser has a strong incentive to protect its reputation.

Benefits Association with Requirements
The paper also notes that the Literature Review found that academic studies offer little support for the view that requiring an independent chair would improve mutual fund governance and limited (and at times contradictory) evidence that more independent boards are beneficial to funds and their shareholders. It expresses concurrence with these broad findings and summarizes the relevant academic research.

The paper also examines the analysis in the OEA's Power Study concerning possible reasons for the lack of statistical evidence that requiring an independent chair would benefit fund shareholders, either through better fund performance or lower expense ratios. It questions the Power Study suggestion that the lack of statistical evidence of benefits may be attributable to the limitations of statistics and data, and concludes that existing studies have found no benefit to having an independent chair because there is no consistent relationship between board chair status and fund performance or expense ratios. It interprets this lack of proven benefits as indicating that there is no reason to believe that one approach is preferable to another.

Costs of Implementing the Requirements
The paper briefly discusses the costs of the independent chair and 75 percent board independence requirements, reiterating the Institute's concern that they will have a disproportionate impact on small fund advisers.

Related Links
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