Before leaving as Securities and Exchange Commission chairman, William Donaldson pushed through several new regulations. One concerning new rules for mutual funds has perhaps had the most influence on individual investors and has generated the most controversy. On the last day of his tenure, Donaldson was able to pass the rules on a 3-2 vote.
Interestingly enough, even the U.S. Court of Appeals had concerns about the new mutual fund regulations. Essentially, the court wanted a closer look at the costs of the regulations relative to the benefits. The decision was the result of a lawsuit from the U.S. Chamber of Commerce.
Two of the rules: Mutual funds will need independent chairpersons, and 75% of a mutual fund's board must be composed of independent members.
To understand the debate, it's important to look at the roots of mutual fund regulation: the Investment Company Act of 1940. Because of the abuses of mutual funds during the 1920s, Congress wanted to provide federal regulation of the mutual fund industry -- enforced by the SEC.
The 1940 act separates the mutual fund into two segments. First, there is the fund itself, which holds the securities and is owned by the shareholders (like you and me). Next, there is an advisor, which manages the investments of the fund. Each fund has a board of directors, whose duties include hiring and monitoring the advisor, as well as determining the fees for the advisor.
Thus, it is almost impossible for the management company to abscond with securities in the fund. Basically, if the advisor (the individual responsible for investment decisions) also has control of the securities, there's an opportunity to take the securities (which actually happened during the 1920s). However, as seen with the mutual fund scandals a few years ago, the system is not fail-safe.
According to Donaldson, there is a conflict of interest if the chairperson of a fund is also part of the fund's advisor. Might the board be more inclined to vote for higher compensation? Might it be more forgiving if the advisor's performance is subpar?
Critics claim that there is little evidence to support that Donaldson's new rules will result in better governance of mutual funds. As aforementioned, significant debate also exists as to whether added costs of regulation/compliance will prove prohibitive to mutual fund operations (fattening cost structures and resulting in higher fees to individual investors -- thus lowering overall returns). Then again, roughly 80% of U.S. mutual funds have chairpersons that are not independent. It stands to reason that there are not enough examples to determine the effectiveness (or lack thereof) of the new rules.
The critics also say that the industry has already made great strides in terms of compliance. The negative publicity from Eliot Spitzer's high-profile campaign against the industry certainly has awakened companies to the need for better internal controls.
In his defense, Donaldson is no stranger to Wall Street. He started a legendary firm, Donaldson, Lufkin & Jenrette, more than 45 years ago. Since then, he has served as the CEO of the New York Stock Exchange and even the CEO of Aetna (NYSE:AET). If anyone understands the problems of conflicts of interest, he certainly does.
True, it's more than likely that the mutual fund industry is much more vigilant in terms of preventing scandals -- its continued well-being depends upon it! But, over time, investors will forget, and temptations might arise for the industry, or groups within, to push the envelope once again. Thus, it's my opinion that tougher regulations, to deal with the inherent conflicts of interest of mutual funds, looks like a way to protect the interests of shareholders -- which, after all, is the duty of the SEC.
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Fool contributor Tom Taulli does not own any of the shares mentioned in this article.
