The New Rule That Has Funds Fuming

The SEC now requires that mutual funds disclose their proxy votes. Despite the grumbling, it's a victory for stronger corporate governance

By Amey Stone

When you consider the array of financial-reform proposals being bandied about these days, a new Securities & Exchange Commission rule that requires mutual funds to disclose publicly how they voted on proxy items seems pretty mild. Passed Jan. 23, the rule says fund companies must start listing their votes on their Web sites by August, 2004. It also calls for funds to have formal guidelines for how they vote, but that's something most fund companies have long had anyway.

In terms of providing investors with a new tool to make investment decisions, the rule isn't that dramatic, either -- especially compared to one still on the table that would require fund companies to disclose their holdings every three months, instead of just twice a year. Yet the new rule struck a nerve with the fund industry, which argued, among other points, that the expense would be onerous and that the fund-management process would be politicized.

Chief executives of archrivals Fidelity and Vanguard even teamed up to write a opinion piece on The Wall Street Journal editorial page, arguing that proxy-voting disclosure would open up fund managers to "thinly veiled intimidation from activist groups" and "distract them from more critical issues in judging funds -- like investment objectives, long-term performance and risk." Industry trade group the Investment Company Institute issued a release saying the rule "overreaches" and urging the SEC "to revisit the effectiveness" at a later date.


  Why have fund-industry leaders fought proxy-voting disclosure with such passion? Because it means fund companies, which control roughly 20% of the stock market, are going to have to pay a lot more attention to corporate-governance issues. Before, they had no real incentive to get involved in proxy fights -- if they didn't like what management was doing, they could simply sell the shares. If they liked management, why rock the boat?

Now that fund owners (along with shareholder-activist groups) will be watching, they'll have no choice but to get involved in proxy fights. And they may have to take tough stands that go against the wishes of management at the stocks they own.

This is something large fund companies rarely do, say shareholder activists. By doing such things as endorsing excessive pay packages, letting insiders onto board audit and compensation committees, and allowing the repricing of underwater stock options, "the institutional investor community has been an enabler for the bad behavior of corporate scoundrels," says Nell Minow, editor of the corporate governance research Web site, The Corporate Library. "People who own shares in funds deserve better than that."


  Plus, the largest fund companies, which also manage corporate 401(k) funds, have a potential conflict of interest. If they hope to win the job of managing a company's 401(k) plan, siding with management could theoretically give them a leg up, says Minow. The most public example about concern of such a conflict: the Hewlett family's lawsuit alleging that Deutsche Asset Management decided to endorse last year's Hewlett-Packard Compaq (HPQ ) merger after receiving lucrative fee business from HP, says Minow.

In another example, Mercer Bullard, president of Fund Democracy, a shareholder-advocacy group, says Frank Savage, who was a director at Enron (ENRNQ ), would not have been reelected to the board of Lockheed Martin (LMT ) if fund companies were required to say publicly how they voted. Savage's appointment to Lockheed's board was opposed by Institutional Shareholder Services, a proxy-voting advisory firm hired by many fund companies.

Thanks to the new rule, shareholders can use fund records as a way to see how managers voted on issues they care about. For most investors, a vote on a single issue wouldn't be enough to make them switch funds, but such data could be important when deciding between two index funds, says Minow. Big fund companies may face more competition from smaller rivals that promise to support certain social policies or religious beliefs through their investment decisions. Indeed, many socially responsible funds advocated strongly for the new rule.


  More significant, the new rule will mean shareholder-activist groups have a new tool at their disposal -- which seems to be what really fueled the fund-industry opposition. Even if individual fund investors don't check, you can bet that shareholder-rights groups like Minow's and Bullard's will keep close tallies of votes. They're sure to put lots of new pressure on fund companies to vote in favor of what are understood to be strong corporate-governance practices.

"The pending rule requiring more portfolio disclosure is probably more important to mutual-fund shareholders," concedes Bullard. "But proxy-voting disclosure will have a greater impact on America's economy. It's the beginning of institutional shareholders being held more accountable for how they invest."

Fund companies say the rule won't have any effect on how they vote. "We've always fulfilled our fiduciary responsibility to vote on behalf of shareholders," says John Woerth, a spokesman at Vanguard, which manages $300 billion in stock holdings. "Disclosing our votes won't change that."


  Smaller fund companies don't seem too perturbed by the new rule. "I must be missing something," says Don Ross, chief investment officer at Armada Funds. Even though he thinks fund companies may have been unfairly singled out by the rule, he says he's happy to disclose his voting record. "I'm an open book. I'll tell anyone how I voted."

All the controversy may amount to no more than a few headaches for some big fund companies. That's a small price to pay if it means institutional investors are going to start doing a better job of holding management's feet to the fire on tough corporate-governance issues.

"Ten years from now, when we look back at all the post-Enron reforms, this will be one of the most significant," Minow says. While that may be a bit of a stretch, she has a point when she argues that all the increased disclosure and financial reforms being put in place now won't mean much if shareholders don't take a more active role. A simple measure like requiring funds to disclose proxy votes may well prove key to ensuring that.

Stone is an associate editor of BusinessWeek Online and covers the markets as a Street Wise columnist and mutual funds in her Mutual Funds Maven column

Edited by Patricia O'Connell

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