A Practical Framework for Assessing Fund Directors’ Governance Risk - April 2013 Print E-mail
Written by C. Meyrick Payne and Jay Keeshan, Management Practice Inc. (MPI)   

     The purpose of this MPI Bulletin is to provide mutual fund directors with a practical framework to oversee risk. This is addressed in three steps: first is assessing known risks such as the absolute risk of errors, omissions, malfeasance or human error; second is overseeing the available procedural mitigation against these risks, including compliance procedures, outside and internal audit, and business risk management techniques; and third is managing the residual risks where fund directors need to be particularly diligent in their governance.


     Fund governance risk is best envisaged as a graphic where the polices, procedures and functions of a mutual fund are divided into three components: (a) customer facing functions, (b) processing and operations and (c) investments and portfolio transactions. Under each of these components are key examples of functions where the fund directors face governance risk.





     Within this framework there are mitigation procedures including numerous levels of compliance, internal and external audits, and risk management and exposure tools. Importantly to fund directors, these are not evenly spread among the three components nor equally effective for all functions for which fund directors have oversight responsibility.

     The external audit procedures are focused on processing and operations from which the numbers for the financial statements are typically derived. Of particular import to the fund directors is the auditors’ analysis and verification of the portfolio valuation. Both the law and regulations specify that the fund directors are responsible for the fair representation of the daily net asset value of the fund. The auditors’ review, when combined with the judicious use of independent pricing services, provides great reassurance to fund directors.

     On the other hand external audits do comparatively little in the customer facing functions or investments and portfolio transactions areas. These are left to various components of the compliance infrastructure. Customer facing functions tend to be overseen by the CCO and compliance department of the broker/dealer or distribution company. Investments and portfolio transactions tend to be overseen by the CCO of the investment adviser, assisted by the compliance department located within the Chief Investment Officer’s department.  In addition there is almost certainly a risk management committee either of the parent company or investment adviser. The fund director’s responsibility is to ensure that these multiple compliance functions work together effectively.


     The residual governance risk for fund directors is the net exposure leftover after the mitigation procedures are put into effect. Not surprisingly, the governance risk faced by fund directors will differ across complexes, but certain topics are almost always problematic:

  1. Prospectus risk: Fund directors must be familiar with what is in the prospectus, given that they explicitly sign these representations to shareholders, are bound by its terms and conditions, and are evaluated by the regulators and plaintiff’s bar by how well they meet their designated responsibilities.
  2. Various forms of revenue sharing to gain distribution and assets: Sub-transfer agency and sub-accounting fees are of particular concern which, when charged to the fund, need to be quantifiably justified.
  3. Market timing: The SEC has adopted a series of forensic tests to ascertain if a fund is subject to market timing. At the very least the fund directors need to use similar tests to analyze if it is occurring.
  4. Fair value pricing: Valuation of the fund portfolio will always be an essential responsibility of fund directors. Fortunately many mechanisms are in place to ensure this is correct. An especially tricky part is the delineation of portfolio securities into the three levels of valuation designated by the accounting profession and, within level 3, any fair valuation which needs to be developed.
  5. Soft dollars: The law permits the use of brokerage commissions for investment research; the question for fund directors is how to reconcile these with “best execution” which is also their responsibility, and notoriously difficult to measure.
  6. Affiliated transactions: Any transaction between the fund and an affiliate of the investment advisor deserves special attention, particularly if the fees paid differ from those available from an independent service provider.
  7. Fees and expenses: The SEC has recently instituted a process by which they look for excessive fees; clearly fund directors need to be especially diligent when a fund has either higher advisory fees or total expenses than its applicable investment category or peer group.
  8. 12b-1 Distribution Fees: Each year the fund directors have to reauthorize any such fees on the grounds that the existing shareholders benefit from them. With many funds in net redemptions or closed to new investors, these justifications are increasingly difficult to make.
     An assessment of governance risk is a difficult and painstaking process. This framework provides a practical starting point for fund directors who want to evaluate where they stand.
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