Whom Is Fidelity's CEO Fighting For?

Fidelity CEO Edward "Ned" Johnson III just won't quit. In July 2004, the SEC passed a new rule that will require, among other things, that fund boards have independent chairs by Jan. 15, 2006. Johnson and others had objected vociferously to the rule, despite its endorsement by the Mutual Fund Director's Forum, a national organization of independent fund directors.

While it is Johnson's right to object to proposed rules he doesn't like, once the rule was passed, that should have been the end of it. However, in late 2004, Senator Judd Gregg of New Hampshire inserted language in a completely unrelated bill that requires the SEC to undertake a study proving that funds with independently chaired boards are better than those with interested chairs. And according to www.opensecrets.org Fidelity's "PAC, its individual members or employees or owners, and those individuals' immediate families" were the largest contributors to Gregg in the last election cycle. It's also worth noting that Fidelity is a large employer in New Hampshire, as its fixed-income operations are headquartered in Merrimack.

A Little Background
So what is Johnson so worked up about? Let's first examine how mutual funds are structured. Although mutual funds are commonly named after their advisors ( Fidelity Contrafund (FCNTX), for example), they are independent, public companies over which the advisor has no inherent legal control. The ultimate responsibility for running a fund lies with its board of directors, who typically contract with an advisor (such as Fidelity or Vanguard) to actually manage the portfolio. The board will also contract with other entities (often, these end up being affiliates of the advisor) to provide other services, including transfer agency, distribution, and custodial services.

It is the board's responsibility to make sure that it negotiates a good deal with these various service providers on behalf of shareholders, and to protect the fund's shareholders against actions that might result in harm to the fund or otherwise compromise shareholders' interests.

An Inherent Conflict of Interest
A board composed mostly of parties that are beholden to one or more of its service providers just can't be expected do its job effectively. Ned Johnson, for example, must pursue policies that are good for Fidelity as a firm (i.e., policies that lead to growth in revenues and profitability). These policies may occasionally conflict with what is good for fund shareholders. After all, if your goal is to maximize the growth of your advisory business, how willing are you going to be to close funds before their asset bases become so large that it hurts their managers' ability to run them effectively? That's why the SEC has required since July 2002 that most fund boards have a majority of directors who are independent of the fund advisor and its other service providers.

The New Rule
Until now, the SEC has allowed fund boards to be chaired by a director who is not independent. In many cases, the board chair is the CEO of the fund advisor, as is the case at Fidelity. The board chair's role is clearly an important one. As the SEC noted in its Final Rule "Investment Company Governance", dated July 27, 2004, the board's chair ". . .can play an important role in setting the agenda of the board, and in establishing a boardroom culture that can foster the type of meaningful dialogue between fund management and independent directors that is critical for healthy fund governance. The chairman can play an important role in providing a check on the adviser, in negotiating the best deal for shareholders when considering the advisory contract, and in providing leadership to the board that focuses on the long-term interests of investors."

The Mutual Fund Directors Forum agreed, writing in a letter dated May 14, 2004, from Allan S. Mostoff, president, and David S. Ruder, chairman: ". . . if they [independent directors] are to be truly empowered to evaluate and approve contracts on behalf of the fund and to monitor objectively the performance of the investment adviser and all other fund service providers, the independent directors should not be led in that function by an employee of the investment adviser or other service providers."

Johnson's Arguments Don't Hold Water
Johnson sees things differently. He argues first that he has a substantial investment in Fidelity funds, and that this ensures he will act in shareholders' interests. To which we say: Prove it. Johnson should tell shareholders what percent of his wealth is invested in Fidelity funds, and--crucially--what percent is in other investments, including his ownership interest in the advisory firm. Until he does this, we can't take this argument seriously.

Johnson also argues that the profitability of the advisor depends on its ability to deliver good performance. This is an oversimplification. Funds can be allowed to get too large, for example, and sink from being great to being mediocre performers, but the fund family can often count on most of its shareholders staying the course (and paying fees) as long as performance isn't awful. Further, neither of Johnson's arguments is born out by the facts. Fidelity is notorious for allowing its funds to get so bloated that managers are faced with portfolio construction challenges they shouldn't have to deal with. That helps fatten Fidelity's fee stream, but it can harm shareholders in the funds.  Fidelity Magellan (FMAGX) was once the firm's flagship, but it grew to more than $100 billion and subsequently struggled. No matter: Fidelity still collected more than $300 million in fees for running this one fund in the year ended March 31, 2004. If the firm is going to sacrifice the flexibility of its funds by allowing them to grow so large, the board ought to negotiate significantly lower fees.

Johnson also argues that there's no evidence that independent chairs can do a better job than interested chairs. But there are so few independent chairs that there is no way to accurately assess this. Fidelity commissioned a study that purported to do so, but it was only able to find 14 boards with independent chairs, and nine of them were bank-advised funds, and most oversaw funds at much smaller shops than the interested chairs at groups the study compared them with. The extremely small sample size and additional factors undermine any utility the study might have had.

Further, when something on its face has so much to recommend it and has the support of a significant group representing the interests of independent directors, the onus should be on its opponents to prove that it would be bad. Johnson attempts to do this by arguing that the rule would deprive the board of the expertise of a seasoned industry executive. Nonsense. Johnson could still be on the board, just not as chair. Further, the board can demand to talk to whomever it wants, whenever it wants. If it wanted Johnson's guidance, the board could go directly to him. If it wants some other insider's advice, it could get it just as easily.

Some of the opponents of the independent chair rule have argued that the chair's potion is unimportant, and the rule is therefore unnecessary. Johnson doesn't voice this, and it's clear why. It's a bad argument. That's clear from the fact that so many interested chairs are fighting the rule tooth and nail. If it's truly unimportant, you wouldn't expect them to care nearly so much.

What's in It for Interested Chairs?
Johnson has yet to present a compelling argument for why interested chairs are good for mutual funds. On the other hand, it's pretty clear that keeping control of the board has been good to mutual fund executives. Just look at the profitability of a typical asset manager and the alarmingly mediocre performance of so many funds. If the chair had focused the board on the problem of asset-bloat at Fidelity sooner, Magellan might still be great today and Joel Tillinghast of  Fidelity Low Priced Stock (FLPSX) wouldn't be saddled with the extreme challenge of putting $35 billion to work in small- and mid-cap stocks. (This is not a problem that's unique to Fidelity--American Funds, to name just one example, is facing asset-bloat issues of its own) But with Johnson as chair, the board failed to take action until it was too late. Most investors can do without that brand of expertise.