Maryland Legislation

Maryland Considers Protection for Self-Dealing Fund Directors Act

On April 10, Maryland Governor Parris Glendenning signed a law that would allow a self-dealing director to prevent a fund from suing an entity that defrauded the fund -- even if the director owns or runs the entity.

The first time this law was enacted, a Maryland court declared it unconstitutional (click on Opinions, search Year 200 opinions by appellant's name, scroll to Migdal v. State, and click on file). The second time it was enacted, it was again challenged in court. Expecting this second challenge to succeed as well, the Maryland legislature passed the bill a third time.

The new law will almost certainly be struck down again. Not only is the law void as a matter of public policy, it is inconsistent with federal law. Further, the law is illegally retroactive. These claims will be asserted by Fund Democracy and other consumer groups, as well as plaintiffs' lawyers. Stay tuned for further developments.

More information about the new law is provided below and in Fund Democracy's testimony, on behalf of itself and the Consumer Federation of America, on March 28 before the Economic Matters Committee of the Maryland House of Delegates. Mercer Bullard also discussed the new law on Tom Greeves' Fee-Only radio show on April 17.

For more articles on the law, see: Theo Francis, Maryland Law Seems to Offer Virtually Unlimited Returns, The Wall Street Journal (Apr. 20, 2001); Michael Dresser, Mutual-Fund Bill Has Familiar Ring, The Baltimore Sun (Apr. 6, 2001) Sarah O'Brien, Maryland Bill Would Limit Fund Lawsuits, Investment News (Mar. 26, 2001); Mercer Bullard, Pretty Please, Can We Sue You?, TheStreet.com (Mar. 7, 2001); Matthew Mosk, Critics Say Md. Favors Firms Over Investors, Washington Post (Mar. 14, 2000); Tamar Frankel, The Different Design of Corporate Governance Under State Law and Federal Law and the Aftermath of the Strougo Case, 7 Investment Lawyer 3 (Feb. 2000).

Protection for Self-Dealing Fund Directors Bill

More than 88 million Americans invest in mutual funds. A large percentage of funds, even those operating in other states, have incorporated in Maryland to take advantage of management-friendly laws. Regardless of where a shareholder sues a fund, Maryland law applies.

In order to sue a fund, in many instances fund shareholders must first ask permission from the fund's directors. This is known as the "demand requirement." If the directors do not grant permission, then shareholders generally can't sue -- unless a court decides that the "demand" was futile, such as when the directors have a conflict of interest that prevents them from objectively evaluating the merits of the suit.

The Bill in Practice

For example, imagine a company overcharges a fund for, let's say, printing prospectuses. Shareholders would have to make a "demand" on the fund's directors to sue the company and recover the overcharges. If the directors were officers of the company, however, the "demand" would be "futile" (i.e., unnecessary) and shareholders could proceed without the directors' permission.

But the Maryland law will require that courts treat these self-interested directors as independent and disregard the fact that they had a personal interest in rejecting shareholders' demand. Why? Because the law requires that courts treat directors as independent if they are independent under federal law (i.e., not "interested persons"). Under federal law, you can be an officer of a company that does business with a fund and still qualify as independent.

Independent in Law, Not in Fact

Congress knew the federal law definition of independent was quite narrow. So it gave the Securities and Exchange Commission specific authority to deem technically independent directors who had significant conflicts of interest to be nonindependent.

In late 1999, the SEC provided the industry with a laundry list of situations when it would consider technically independent directors to be nonindependent. Even the trade group for fund management companies, the Investment Company Institute, chimed in, and issued a report recommending that certain technically independent persons not serve as independent fund directors.

The Maryland law conflicts with both the SEC's and the ICI's positions. It would treat all technically independent directors as independent in fact, regardless of personal conflicts they may have.

Such persons include:

Former directors, officers and employees of the fund's manager;
Relatives of current directors, officers and employees of the fund's manager;
Current directors, officers and employees of other companies providing services to the fund;
Current directors, officers and employees of companies in which the fund invests;
Shareholders in companies in which the fund invests; and
Directors, officers and employees of entities that engage in transactions with the fund.

How Did We Get Here?

The Maryland law was prompted by a 1997 federal court decision. The court found that a director could be deemed nonindependent based on the amount of his compensation, or the number of fund boards on which he served.

In that case, neither the directors' compensation nor the number of funds they supervised were outside industry norms. The fund industry was concerned -- with some justification -- that fund directors would be unable to reject frivolous lawsuits because a large percentage of them would be deemed nonindependent under the court's ruling.

The court's questionable ruling did not stick, however, and its position on compensation and board duties has never been approved by an appellate court. Some might argue that this showed that the judicial system was working. The fund industry believed that legislative intervention was necessary.

One might have expected a law that prohibited courts from considering directors' compensation or their board duties when evaluating their independence. Although this kind of fact-specific determination is best left to the courts, the law would be a defensible approach, and would not have dramatic adverse consequences for fund shareholders.

But the fund industry, apparently sensing an opportunity to exploit the Maryland legislature's unfamiliarity with federal mutual fund laws, went for broke. It pushed through a law that required that courts treat even blatantly conflicted directors -- directors that the industry itself has recommended not be treated as independent -- as independent under Maryland law.

This classic case of throwing the baby out with the bath water will result in directors with a personal interest in a fund not bringing a lawsuit being authorized to prevent the suit from going forward.

What You Can Do

There's not much to do for now. The new law does not take effect until June 1. Fund Democracy is preparing a legal challenge to the law, which it expects to file sometime this summer. Stay tuned for further developments.

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