Throughout the course of the long debate over the SEC’s proposed rule to require 75% independent board members and an independent chair on a mutual fund board, many observers have come to appreciate that the change is relatively small and quite subtle. After all the Audit, Nominating and Contracts committees are all chaired by independents and most fund groups already have a lead independent director. The real difference is in the explicit control of the board’s agenda. 

The purpose of this article is to share an approach to evaluate the effectiveness of third party service provider operations and compliance programs. The law and the supporting regulations state that a Fund Board must take responsibility for the policies and procedures of each of its service providers. These usually include any sub-adviser, transfer agent, custodian, fund accountant or pricing service. In turn the Board looks to the Chief Compliance Officer (CCO), who provides the board with an annual written report about each of its service providers.

The report must address, at a minimum: (1) the operation of policies and procedures of the fund and each service provider since the last report, (2) any material changes to the policies and procedures since the last report, (3) any recommendations for material changes to the policies and procedures as a result of the annual review, and (4) any material compliance matters since the date of the last report.

Mutual fund boards typically evaluate their compensation annually or bi-annually, often using the traditional method of comparing their compensation to that of a peer group of directors with similar governance responsibilities; that is, similar assets under management and number of funds governed. They will often try to set their pay at the 50th percentile—or perhaps higher, say 75%—of the peer group pay range. This approach potentially facilitates a “Lake Wobegone” upward spiral effect, in which all mutual fund directors are “above average” and pay levels continue to ratchet up on their own momentum.
Whether these increases are merited or not, this “outside-in” method of setting director pay may not truly reflect a fair value for the job. A more solid and rational technique would involve evaluating the various aspects and requirements of the job to determine what rate of pay would be appropriate to attract, motivate, and retain appropriate and competent directors. This requires more of an “inside out” approach. The E3 + O methodology described below examines the effort, expertise, exposure, as well as an additional element—opportunity cost—involved with serving as a mutual fund director.