A recent court decision involving Scudder, Stevens & Clark's fund directors has prompted discussion over what shape a mutual fund's board should take.
The judge deemed several of the directors not to be independent because they served so many Scudder funds that their compensation had become excessive.
If the Scudder decision is upheld on appeal, then many fund families would have to add new trustees and organize into a clustered board rather than a pooled board.
These two prevalent structures for mutual fund boards have distinct advantages and disadvantages. (The discussion of these structures that follows should not be construed as legal advice.)
A pooled board is one where there is only a single set of directors for a fund complex; a clustered board is one where there are several boards, each governing a particular set of funds.
Sometimes clustered boards exist because of an acquisition of new fund families, sometimes because a greater range of skills sets are required than currently available, and sometimes because the work load was just too great.
From the investment management company's point of view, a pooled board has advantages. The efficiency of meetings is increased and the danger from unpredictable or uninformed directors is reduced.
A great deal of management company effort goes into a directors meeting. The executives involved are usually the most senior who make critical marketing, investment, distribution, and wholesaling decisions in addition to legal and compliance responsibilities.
Management company executives may be justified in believing that the investor is more interested in investment research and portfolio training than governance duties.
In addition, clustered boards are up to five times more expensive to maintain. In the Investment Company Institute's 1997 survey on independent directors, the average annual cost of a pooled board was $255,000, compared with $1,580,000 for a clustered board.
From the directors' point of view, pooled boards compensate better since their responsibilities are broader in scope. For example, the institute's study showed that a director of a $30 billion pooled board received an average of $98,300, while a director of a clustered board of the same size received $67,800.
On the other hand, a director of a pooled board will meet more frequently and have more committee service.
From the investors' point of view, the cost issue is unlikely to be significant because the total board cost pales in comparison to investment management and operations cost.
Board expenses make up less than 2% of the total expense ratio. The board's effectiveness at representing the investors' interest, particularly as it relates to performance, expense control, and advisory fee negotiation, is more important.
The question becomes one of how best the directors organize themselves to serve the shareholders' interest. The Scudder judge clearly thinks that smaller clusters are better.
The nature and composition of clusters will depend on the specific complex. Sensible alternatives seem to include investment types (such as equity, fixed-income, money market) or style (such as aggressive, balanced, or conservative).
Another alternative is to construct the clusters to reflect the organization and work teams within the management company. After all, a great deal of governance involves understanding and overseeing the people who do the job within the investment adviser. If the management company is organized by investment type then perhaps the boards should be also.
The Scudder judge would undoubtedly want to limit the size of the cluster even within these perimeters. If a complex is large enough and has a wide range of equity investment objectives, a cluster might be divided into U.S. domestic, small cap, emerging markets, and technology. Once again this pattern is likely to reflect the organization of the management company.
Since management companies are in a constant state of growth and flux, perhaps board clusters should be allowed to change as well. This would bring a climate of rotation to the board, keeping it lively and fresh.
An advantage of clusters constructed in this way is that compensation could be capped for a particular cluster to reflect the effort, expertise, and exposure involved. This would prevent trustee compensation growing every time a new fund in the same cluster is added.
There are several functions that are common to all clusters within a fund family; audit, nominating, compensation come to mind. A committee of each cluster board meeting as one might handle these. In this way the time and expense of the management company and outside professionals could be cost-effectively used.