The Deception Series, Part 7--The Role of the Mutual Fund Company Board of Directors

Part 7--The Role of the Mutual Fund Company Board of Trustees

Every mutual fund company has a board of trustees who oversee the fund company's business practices, so they comply with prevailing corporate governance standards, regulations and the law. In part, this means the Board follows good corporate governance standards.

But how does a board isolate the needs of shareholders as it simultaneously offers and advisor paid fee (APF) arrangement?

This is a tough question since the APF is essentially based on a vague definition of disclosure as it is implemented through third party advisers. It also practically puts the interests of the fund company ahead of shareholders.

It also effectively rewards distributors and their investment adviser agents for voluntarily entering into a conflict of interest with their clients for the sake of receiving a monetary reward. While the APF may be legal, it is an ethical tar pit which most other mutual fund companies in the industry have deliberately avoided.

Hiding behind Language
The language of the trustees provides a clue as to how they perform their duties and skirt controversial issues. In an unpublished interview with three trustees from the WM Group of Funds in 2004, three trustees talked about their independence, focus on key issues, and what makes the WM funds exceptional.

In one part of this interview, a trustee noted that the funds’ operation are “transparent, which has helped us avoid the problems faced by other fund companies.” (This statement was made before the APF-related class action lawsuits were filed.)

In the case of the WM board which was in place for the vast majority of the time the APF has been in effect, I believe the board failed in their role to adequately inform shareholders about the APF. This same fault was also passed on to the current Principal Funds board which has also successfully evaded dealing with this ethical problem.

Over the years, this has remains a glaring omission since the APF was the virtual lifeblood of the entire mutual fund company. It drove all WM and a significant part of Principal Fund sales, paid huge commissions to wholesalers, and other executives, yet at best, it was an embarrassing secret.

The only comfort the APF provided to the board was that it was considered legal. I am sure the ethics of the APF were never discussed, and the board was kept-well informed about other lawsuits concerning revenue-sharing deals.

In an unpublished interview with three board members, the issue of communications and transparency were raised. One of the trustees, Kristianne Blake, then chairwoman of the Operations & Distributions Committee and now a member of two boards at the Principal Financial Group, said "We try to be forthright with our shareholders. That is how we approach all of our discussions."

The definition of forthright is important since the word "forthright" means "going straight to the point; frank; direct" (Websters Dictionary) which is the exact opposite of how the APF disclosure to shareholders was done in daily practice. Blake's misuse of the term "forthright" as it regards the APF, which she should know well, is not a semantic mistake.

Instead, it indicates a distorted or naive view of how this under-the-table commission has been rewarded and used over the past decade to reward financial advisers and salespeople at the expense of investors. This is a typical situation when a board of trustees becomes inbred and devoid of outside critical opinions and input.

Of course, the trustees agreed that the lofty goal of disclosure should be followed by the industry, but when it came to following that simple practice inside their own fund company they were asleep at the wheel.

This issue is especially ironic today since the Principal Financial Group (NYSE: PFG), the parent company of the Principal Funds, received an industry award in June 2009 for being one of the most ethical companies in the financial services industry.