Access to the Mutual Fund Proxy

This post comes to us from Jennifer Taub, a Senior Lecturer and Coordinator of the Business Law Program at the University of Massachusetts Amherst.

One topic missing from the early analysis of the SEC’s proxy access rulemaking [1] has been mutual funds as issuers. Though, a few experts have recognized the importance of mutual funds as shareholders. For example, Ira Millstein and Stephen Davis welcomed proxy access and noted that it “places a colossal bet that shareholders will patrol the market. Up to now many, including major mutual funds, have simply voted shares on autopilot.” [2]

Indeed, given that they hold 24% of US corporate equity, [3] the sway of mutual funds as shareholders is significant. This voting power might be tapped to reach the threshold to nominate corporate directors. And, this voting power will be used to support or block shareholder director nominees and shareholder proposals related to director nominations and elections. Notwithstanding this capacity, activists should not expect much from the largest mainstream fund families who historically favor management when casting proxy votes on shareholder-sponsored corporate governance proposals. [4]

However, beyond considering their role as shareholders, we should remember that mutual funds are issuers and have shareholders of their own. And they are numerous. Nearly 90 million Americans own mutual funds. [5] And, mutual funds are the “primary means by which individuals investors participate in the financial markets.” [6] As of July 2010, mutual funds had approximately $10.9 trillion in assets. [7] Moreover, their slumbering shareholders are slowly awakening, initiating proposals and voting. [8] Thus, this topic deserves our attention.

In a recent rulemaking, over industry objections, [9] the SEC brought registered investment companies (a term that includes, for example, mutual funds, close-end funds and ETFs) within the new proxy access regime. Notable industry participants who supported access were the Mutual Fund Directors Forum [10] (the non-profit that serves independent directors of mutual funds) and the TIAA-CREF fund complex. [11] Large institutional shareholders, Cal-PERs [12] and AFSCME [13] encouraged access, and this author also provided a comment letter in support. [14]

In the final rule release, the SEC made note of a variety of arguments opposing inclusion. [15] One argument was that fund shareholders are adequately protected through voting rights on a variety of matters, and because they can sue for breach of fiduciary duty. Another argument was that the election of a solo board member would be a problem because most fund families have a single (“unitary”) board that oversees all funds in the complex or they use a cluster board structure where two or more boards oversee groupings of funds. Opponents argued that nomination and election of a new board member to just a single fund would make board meetings more time consuming and expensive and difficult given concerns including around confidentiality. Another argument was that with a contested election, it would be challenging and thus costly to achieve a quorum.

The Commission responded to the objections raised. Regarding board structure, it was noted that while around 83% of fund complexes have a unitary board, the average number of funds per complex is five and median is one. [16] In addition, confidentiality agreements could be used for the new director. The SEC also suggested that the costs of compliance would be lower than at operating companies, given the infrequency of meetings, the passive retail shareholder base and because the continuous holdings requirement would be a higher hurdle given the higher proportion of retail fund owners. [17]

Regarding the extra cost, including those associated with achieving a quorum, on balance, competition created in the board nomination process, they explained, might help create leverage in board negotiations with the fund family adviser over fees. In other words, if few shareholders have the will or opportunity to use the rule, it will not be costly. And, if they do act, additional costs may be offset by increased bargaining power with managers.

Ultimately, the SEC determined that:

“These state law rights [to nominate and elect directors] apply to the shareholders of investment companies, including each investment company in a fund complex, regardless of whether or not the fund complex utilizes a unitary or cluster board. Moreover, although investment companies and their boards may have different functions from non-investment companies and their boards, investment company boards, like the boards of other companies, have significant responsibilities in protecting shareholder interests, such as the approval of advisory contracts and fees. Therefore, we are not persuaded that exempting registered investment companies would be consistent with our goals.” [18]

As a result, under Rule 14a-11, mutual funds must give eligible shareholders access to the proxy to nominate directors. And, as is the case with operating companies, for mutual funds, eligibility is limited to shareholders or groups of shareholders with 3% (in this case of the mutual fund’s net assets) held for at least 3 years prior to submission. In addition, mutual funds are required under Rule 14a-8(i)(8) to give qualifying shareholders (who meet the $2,000 or 1% for 1 year threshold) access to the proxy to propose procedures for director elections and nominations. [19]

One immediate change for mutual funds is the requirement to file an 8-K. Mutual funds, unlike operating companies, typically are organized as state business trusts and rarely hold annual meetings. Nor are they required to solicit proxies from shareholders to elect directors unless less than two-thirds of the sitting board has been elected by shareholders. [20] Beyond those circumstances, funds do hold meetings when they need shareholder approval for matters such as to change fundamental investment policy or concentration policy. [21] The 8-K will be the vehicle to inform fund shareholders of the date by which they must provide notice to the fund in order to include a nominee within the proxy materials.

Other than the new 8-K obligation, the practical effect may seem quite subtle. This is because, as noted above, few mutual funds hold annual meetings. Thus, there will be limited opportunities to exercise the new rights. So, what can we expect? The SEC estimated that in the registered investment company realm, there will only be six director nominees under 14a-1l per year and half of these would be at closed-end funds, not mutual funds. [22] And, under 14a-8(i)(8) the SEC estimated for investment companies, a total of 24 (up from 12) shareholder regarding procedures for including shareholder nominees for director in the proxy. [23]

While this may seem small, the impact may be larger. Just as the Jones v. Harris Associates case, brought by three fund shareholders, resulted in a new factor that all fund boards must consider in evaluating management fees, [24] the election of a single shareholder nominee to the board at one fund has the potential to affect all. [25] Adding some competition to the board nomination process may increase board dependency upon fund shareholders. This may create more bargaining power in board negotiations with fund advisers over fees, expenses and other related matters. Given that boards are loathe to use the “nuclear option” and fire the fund adviser, gaining extra leverage to negotiate more strongly on behalf of fund investors is essential.

Endnotes

[1] See Facilitating Shareholder Director Nominations, Securities Act Release No. 9136, Exchange Act Release No. 62,764, Investment Company Act Release No. 29,384 (Aug. 25, 2010) [hereinafter, Proxy Access Rule].
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[2] Ira Millstein and Stephen Davis, Finally, Governance Becomes Possible, Harvard Law School Forum on Corporate Governance and Financial Regulation, (August 30, 2010, 12:33 p.m.), available at http://blogs.law.harvard.edu/corpgov/2010/08/30/finally-governance-becomes-possible/.
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[3] 2010 Inv. Co. Inst., Investment Company Fact Book 12, fig 1.5 (50th ed. 2010) [hereinafter Inv. Co. Inst. 2010], available at http://www.ici.org/pdf/2010_factbook.pdf, (as of year-end 2009).
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[4] Jennifer S. Taub, Able but Not Willing: The Failure of Mutual Fund Advisers to Advocate for Shareholders’ Rights, 34 J. CORP. L. 843 (2009), available at http://papers.ssrn.com/sol3/papers.cfm?abstract_id=1066831, Gerald F. Davis & E. Han Kim, Business Ties and Proxy Voting by Mutual Funds, 85 J. Fin. Econ. (2007).
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[5] Inv. Co. Inst. 2010, supra note 3, at x (This figure captures direct retail shareholders as well as intermediated. For example, this includes the 68% of fund investors who own through employer-sponsored retirement plans, at 84).
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[6] See Letter from Carolyn McPhillips, Counsel, Mutual Fund Directors Forum, to Elizabeth M. Murphy, U.S. Sec. and Exch. Comm’n (September 19, 2009), available at http://www.sec.gov/comments/s7-13-09/s71309-96.pdf
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[7] Inv. Co. Inst., Trends in Mutual Fund Investing, July 2010 (2010), available at http://www.ici.org/research/stats/trends/trends_07_10
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[8] Recently, a shareholder-sponsored, non-binding resolution for genocide-free investing received 31% of the vote of the shareholders of a fund offered by a large fund family. See, Ross Kerber, US Funds Face Renewed Divestment Calls on Sudan, Reuters, June 2, 2009, available at http://www.reuters.com/article/idUSN0215102920090602
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[9] See Letter from Paul Schott Stevens, President and Chief Executive Officer, Investment Company Institute, to Elizabeth Murphy, U.S. Sec. and Exch. Comm’n (August 17, 2009), [hereinafter, ICI Letter], available at http://sec.gov/comments/s7-10-09/s71009-360.pdf
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[10] See Letter from David B. Smith, Jr., Executive Vice President and General Counsel, Mutual Fund Directors Forum, to Elizabeth M. Murphy, U.S. Sec. and Exch. Comm’n (August 17, 2009) [hereinafter, MFDF Access Letter], available at http://www.sec.gov/comments/s7-10-09/s71009-285.pdf (supporting access but cautioning that shareholders should weigh the costs and benefits, for example, associated with having one fund within a complex with a board member who is not on the other boards.)
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[11] See Letter from Hye-Won Choi, Senior Vice President and Head of Corporate Governance, Teachers Insurance and Annuity Association of America and College Retirement Equity Fund (“TIAA-CREF) to Elizabeth M. Murphy, U.S. Sec. and Exch. Comm’n (August 17, 2009), available at http://www.sec.gov/comments/s7-10-09/s71009-217.pdf (supporting access, though recommending a 5% threshold at the fund complex level).
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[12] See Letter from Joseph A. Dear, Chief Investment Officer, California Public Employees’ Retirement System, to Elizabeth M. Murphy, U.S. Sec. and Exch. Comm’n (August 14, 2009), available at http://www.sec.gov/comments/s7-10-09/s71009-259.pdf
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[13] See Letter from Gerald W. McEntee, International President, http://www.sec.gov/comments/s7-10-09/s71009-88.pdf
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[14] See Letter from Jennifer S. Taub to Elizabeth M. Murphy, U.S. Sec. and Exch. Comm’n (August 13, 2009), available at http://www.sec.gov/comments/s7-10-09/s71009-127.pdf
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[15] See Proxy Access Rule, supra note 1, at 55 – 62.
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[16] Ibid at 57, fn 136.
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[17] See ICI Letter, supra note 9 at 22, fn 54 (as of December 2007, “Retail shareholders held about forty-five percent of the value of operating company shares as of December 2008 [and] sixty-four percent of the value of mutual fund shares.”)
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[18] See Proxy Access Rule, supra note 1, at 58 – 59.
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[19] Ibid at 225.
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[20] See MFDF Access Letter, supra note 10.
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[21] See In re Charles Schwab Corporation Securities Litigation (Apr. 8, 2010), available at http://lawprofessors.typepad.com/files/schwab.040810.pdf and Ropes & Gray Investment Management Update (May 11, 2010), available at http://www.ropesgray.com/imupdatemarchapril2010/
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[22] See Proxy Access Rule, supra note 1, at 275, fn 807.
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[23] Ibid at 290.
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[24] Jones v. Harris Associates, 559 U.S. ___(2010) (In evaluating whether a fund adviser breach its fiduciary duty by charging excessive fees, “comparisons between the fees that an adviser charges a captive mutual fund and the fees that it charges its independent clients” are relevant.), see also Jennifer S. Taub, Jones v. Harris Associates: Let the First Lawsuit Bloom, The Race to the Bottom (March 30, 2010, 10:36 a.m), available at http://www.theracetothebottom.org/miscellaneous/jones-v-harris-associates-let-the-first-lawsuit-bloom.html
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[25] See, Gretchen Morgenson, Elect a Dissident and You May Win a Prize, N.Y. Times, May 23, 2009 (referencing a study conducted by the Investor Responsibility Research Center Institute and Proxy Governance).
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