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The Case of the Missing SEC Studies

Friday, March 2, 2007

Were key reports on mutual fund governance suppressed? The SEC’s own studies weakened the arguments of former Chairman William Donaldson.

Two Securities and Exchange Commission studies on mutual fund governance, which raised questions about a regulation fervently advocated by former Chairman William Donaldson, surfaced just before the end of 2006—nearly two years after they were completed, according to a senior SEC official, and too late to affect a key vote and an appellate court ruling.

In an interview, Donaldson told that the studies were not “suppressed” in any way. “I know that they were circulated,” he said.

Donaldson may be correct, but they were apparently not circulated among all the SEC commissioners who actually had to vote on the fund rule.

Neither Paul Atkins, a commissioner who sparred with Donaldson many times, nor Harvey Goldschmid, a commissioner who was a close ally of Donaldson and has since left the SEC, recalls seeing the studies in 2005. “It was obviously the higher-ups who decided to not make them part of the public record,” Atkins told Bloomberg News. He accused unnamed officials of having “deep-sixed” the studies, which were prepared by the SEC’s Office of Economic Analysis (OEA).

Donaldson (large)An advisor to Christopher Cox, who succeeded Donaldson as chairman in August 2005, told he knows “for a fact” that there were “fairly final drafts” of the studies ready by April 2005.

“It was a mistake not to have circulated these studies to the commissioners,” Atkins told, “but it was a bigger mistake not to have published them for public comment. I am pleased that Chris Cox rectified the public record.”

Cox was notified of the studies last December, after Atkins and another SEC commissioner, Kathleen Casey, learned about them. The studies were posted on the SEC website on December 29, 2006, in an “updated” form. It is unclear how much they were updated since their original drafting. SEC spokesman John Heine said that chief economist Chester Spatt would not be available for comment.

The studies were important because they failed to find reliable empirical evidence to back a rule that Donaldson and the two commission Democrats approved on a 3-2 vote in June 2004. The rule was stuck down by a federal appeals court in June 2005, but was passed again eight days later—and just one day before Donaldson left office—on the same 3-2 vote. The court rejected the rule a second time in April 2006. Under Cox, the SEC reopened the comment period in June and then again in December to allow for responses to the OEA studies. The comment window, which must elapse before the commission can act, closes today.

“This isn’t his battle,” says an advisor to Cox. “But, you know, he has to deal with it.”

The controversial rule required that the chairman and no less than 75 percent of the directors of a mutual fund be independent of management. Many mutual funds argue that the rule is unnecessary, since, as one of the OEA studies concluded, “there is no consistent evidence” linking “chair or board independence” to greater fund performance (in returns to shareholders and expenses). Indeed, some research cited by the OEA suggests that many independent-chaired funds perform worse than management-chaired funds.

The longer of the studies was titled “Literature Review on Independent Mutual Fund Chairs and Directors.” It found that “boards with a greater proportion of independent directors are more likely to make decisions, such as negotiating lower adviser fees, that may potentially lead to higher returns.” But, in fact, “broad cross-sectional analysis reveals little consistent evidence that board composition is related to lower fees and higher returns for fund shareholders.”

A second study, titled “Power Study as Related to Independent Mutual Fund Chairs,” looked at why mutual fund governance research produced such weak results. It concluded: “Existing empirical studies of the effects of mutual fund governance have failed to consistently document a statistically significant relation between fund governance and performance, particularly with respect to board chair independence.

“We suggest that the lack of such evidence may be a result of the limits of standard statistical methods in identifying such a relation and is not necessarily indicative of the failure of such a relationship to exist.”

The controversial rule required that the chairman and no less than 75 percent of the directors of a mutual fund be independent of management.

The mystery of when the reports were written and why they were not made public persists. The U.S. Chamber of Commerce, which mounted the original legal challenge to the fund-governance rule, filed a Freedom of Information Act Request on February 5 to obtain a slew of related materials, including “any notes, written records, correspondence or other documents” stemming from the studies. The Chamber believes “the data reported and analyzed in the studies was available well in advance of” December 2006.

Donaldson, who headed the SEC from 2003 to 2005, acknowledges that the studies were completed before December but claims they were “totally out in the open.” He adds that “not everything is posted on the website.”

In their initial dissent during the first vote on the rule in 2004, Atkins and Cynthia Glassman, a commissioner who left last year to become an official at the Department of Commerce, voiced displeasure that the SEC’s staff had not looked at the empirical evidence. “Despite the existence of empirical data that could have been analyzed to evaluate potential benefits, the proponents [of the mutual fund rule] provided no such analysis,” wrote Atkins and Glassman.

It appears that the studies were done a year later after a directive from Congress demanded that the SEC produce a justification and economic analysis of its fund-governance rule by May 1, 2005. The SEC filed its staff report on the subject in April—around the time the Cox advisor believes “fairly final drafts” of those two OEA studies were completed.

The report detailed the history of mutual fund regulation and the raft of industry scandals that had spurred passage of the new fund-governance rule in 2004. But, in making the case for independent chairmen, the staff couched its argument vaguely: “A fund board is in a better position to protect the interests of the fund… when its chairman does not have the conflicts of interest inherent in the role of an executive of the fund adviser. Leadership by an independent chairman is likely to help the board be more effective in overseeing fund operations and monitoring conflicts of interest.”

When it came time to analyze the “relation between independent chairs and fund performance, expenses and compliance,” the report grew muddier. “We benchmarked our analyses to the approach taken in the Bobroff-Mack Report,” a reference to a study by two economists that was commissioned by Fidelity Investments. The study, which received significant attention, was detrimental to Donaldson’s case. It found that funds with management-affiliated chairmen were more highly regarded by Morningstar (the research firm), had higher returns, and had fees that were the same or lower, on average, than funds with independent chairmen.

Some research cited by the OEA suggests that many independent-chaired funds perform worse than management-chaired funds.

The 2005 SEC staff report to Congress said: “We found evidence that the performance results of the Bobroff-Mack Report are highly sensitive to the sample used and the excess returns measure…. One must take care interpreting the results of any analysis pertaining to the relations between governance and performance broadly defined. Without careful design and methods, researchers may come to inappropriate conclusions. Finding no relation in the data does not confirm that no economically significant relation exists between fund governance and performance.”

These comments in the staff report echo those of the OEA studies, indicating that drafts of the studies were indeed probably completed by the spring of 2005.

According to one high-level SEC source, the studies were circulated at least among the OEA staff, the General Counsel’s office, and the Division of Investment Management. What about the commissioners? “I don’t remember seeing the studies,” says Goldschmid, who served as a commissioner from 2002 to 2005 and voted in favor of the fund-governance statute both times. But, said Goldschmid, who is now a professor at Columbia Law School, “I can’t imagine why this would be an important issue today.”

At any rate, Donaldson did not gain a reputation at the SEC for being persuaded by economic research, whatever it showed. “There are no empirical studies that are worth much,” he said in 2004. “You can do anything you want with numbers.” The purpose of the fund rule, Donaldson now says, was to promote “a range of good governance practices,” not simply “performance.” Its chief motive was “zeroing in on the conflicts of interest that exist.”

But to ignore empirical research would appear to disregard the appellate court ruling in June 2005, which asked that the SEC conduct a thorough cost-benefit analysis of its new rule. The OEA studies, had they been made public, would have aided that analysis. Instead, Donaldson scurried to pass the rule again just eight days after the court ruling. A similar court ruling was issued April 2006, but it took until December for the studies to become public.

Independent directors are far less controversial than independent chairmen. The 1940 Investment Company Act mandated that at least 40 percent of a mutual fund’s directors be independent of management. In 2001, the SEC raised this threshold to at least a majority of a board’s directors. Most funds today have far more, but the rule requires 75 percent.

That figure struck many critics as arbitrary, and one of the OEA studies appeared to support this charge: “Even in cases where director independence is found desirable,” it noted, “the empirical literature is for the most part silent about what specific independence majority requirements are optimal, likely because it is extremely hard to make such statistical identification across a large set of heterogeneous firms.” The implication is that a one-size-fits-all approach may not work best.

Donaldson did not gain a reputation at the SEC for being persuaded by economic research, whatever it showed. ‘There are no empirical studies that are worth much,’ he said in 2004. ‘You can do anything you want with numbers.’

The OEA staff focused on two outside studies, in addition to Bobroff-Mack, that were motivated either “in part or in whole” by the 2004 fund-governance rule. One was conducted by Steve Ferris and Sterling Yan of the University of Missouri-Columbia College of Business. According to the OEA, the authors found “no evidence that funds with higher percentage[s] of independent directors, or independent chairmen, have lower fees.” As Ferris himself put it: “There is no evidence to show that funds with independent chairs charge lower fees or have a greater level of compliance with existing regulations. These were among the primary arguments in favor of this requirement, so it is not clear what benefits this requirement provides.”

The third study was a 2006 working paper by J. Felix Meschke of the University of Minnesota’s Carlson School of Management. This one, said the OEA study, “finds no evidence of a positive relation between board or chair independence and a variety of measures of fund performance. For both equity and bond funds, [Meschke] reports that greater board independence is generally associated with lower returns.” The SEC economists found potential methodological problems with all three studies, but one of their conclusions was this:

Indeed, economic theory suggests that if there are no impediments to markets working efficiently, mutual funds and their shareholders would select governance characteristics—including the presence of an independent chair or the percentage of the board held by independent directors—in an optimal manner. The theory suggests that board structure may be different for individual mutual funds due to differing business conditions, but if chosen optimally is likely to result in little or no expected relation between those structural characteristics and fund performance.

The key phrase there is: “if chosen optimally.” Under Donaldson, critics say, the SEC took that choice out of the hands of shareholders and board directors, imposing instead a regime of obligations that limited options.

Economist James Miller argued at the time that it was “more than a little ironic that the ‘reformers’ would try to strengthen the independence of mutual-fund boards by stripping away boards’ independence in making one of their single most important decisions: the election of a chairman to lead the fund’s operations.” If directors were barred from electing “fund-affiliated” chairmen, wrote Miller, they would potentially be forced to hire “less qualified” chairmen.

The Wall Street Journal recently reported on a compromise measure being debated within the SEC: “a fund would be exempt from [the independent-chair] rule if it met a series of tests, the most significant of which is having a supermajority of independent directors on the board and a lead independent director.” The SEC will probably act in the next few months; but since Cox, unlike Donaldson, has made unanimous 5-0 votes the hallmark of his tenure, a resolution is unclear. At least now, all the data appear to be on the table.

Photography credit: courtesy of the White House

Timeline of Events

June 2004: SEC votes, 3-2, to approve new rule requiring that the chairman and at least three-quarters of board members be independent of company management. Compliance date is set for January 2006.

September 2004: U.S. Chamber of Commerce files suit to stop rule.

April 2005: SEC’s Office of Economic Analysis has completed draft versions of two studies analyzing empirical evidence related to the rule, according to a senior SEC official. The studies cast doubt on rule’s underpinning. Chairman William Donaldson says the studies were circulated, but the commissioners did not all see them, and they were not made public.

June 21, 2005: Federal appellate court strikes rule, arguing that the agency failed to conduct proper analysis.

June 29, 2005: Eight days after the court ruling, the SEC once again passes rule on another 3-2 vote, again with Donaldson joining the two Democrats on the commission. Donaldson leaves the SEC the next day, is replaced a few weeks later by Christopher Cox.

August 2005: Responding to a motion filed by U.S. Chamber, court agrees to stay rule.

April 2006: Appeals court again rejects the rule, sends it back to SEC.

June 2006: SEC reopens comment period and files status report.

August 2006: Comment period ends.

December 2006: SEC extends comment period, posts “updated” versions of the two OEA studies on website.

February 5, 2007: U.S. Chamber files Freedom of Information Act Request to obtain SEC materials related to OEA studies.

March 2, 2007: Comment period scheduled to end.

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