11/15/2014

Trustees: The Shareholders’ Watchdogs

by

Mutual fund boards are the champions of shareholders. But boards and their trustees are still not well understood by investors or their financial advisors. We spoke with three longstanding trustees of the Aquila Group of Funds—John C. Lucking, Thomas A. Christopher, and James A. Gardner—during the September, 2014 quarterly board meetings to learn more about what they do.

Tom Christopher and James Gardner

Tom Christopher and James Gardner

What do mutual fund board trustees do—and why should we care?

TC: We oversee the management and operations of each Aquila fund on behalf of shareholders. We’re the shareholders’ watchdogs. Aquila Group of Funds subcontracts a variety of services—from fund accounting to transfer agency services and, in some cases, to investment sub-advisers (including portfolio managers). As trustees, our job is to review and oversee the performance of those service providers, to verify that agreements with them represent an arm’s-length deal, that they are fair, and competitive.

John Lucking

John Lucking

Every Aquila board includes a member of Aquila’s management team. But by law, a majority of the trustees are independent, as the three of us are.

We’re also shareholders. Every trustee has invested in the funds he or she oversees, oftentimes in substantial amounts. We have skin in the game.

JL: For every decision made by the funds, our job is to ask, “is it good for shareholders.”

JG: That independence is critical. I clearly remember an occasion on which [Aquila founder] Lacy Herrmann realized he wasn’t going to get his way on an issue. He somewhat ruefully commented, “Well, I always said I didn’t want a rubber stamp board.” And I said, “Lacy, we’re your dream come true.”

What convinced you to become an Aquila trustee?

JG: Lacy approached me about helping to build the Oregon board when I was president of Lewis & Clark College in Portland. What sold me was the quality of the operation. I felt I could help fill out the board with people who had the experience, stature, and quality needed.

JL: After getting my PhD in financial modeling at Stanford and working for Phelps Dodge, I became chief economist at Valley National Bank in Phoenix, AZ. At Lacy’s request, I began presenting at Aquila shareholder meetings on the economy and soon was asked to join the board.

One of the big attractions was the people—there’s a variety of backgrounds. The trustees are very concerned with doing a good job and carrying out their fiduciary responsibility. So the variety and the character of the trustees are what I found most attractive.

TC: After a stint at Arthur Young, I relocated to my hometown of Danville, KY to open my own CPA firm. Lacy found me through what was then Aquila’s sub-advisory partner in Kentucky.

The attraction to me was the integrity of the people up and down the line. I recognized the value proposition based on my practice, which included advising wealthy individuals to whom I was already recommending municipal bonds.

In your experience, what makes Aquila unique as a fund manager?

JL: Its integrity. Beyond that, what’s really distinctive about Aquila is its local representation, including on the boards.

The other thing that’s always struck me about Aquila is the annual outreach and shareholder meetings for the municipal bond funds. We learn what shareholders are interested in. And it’s a rigorous exercise to present to a crowd of people with a financial stake in what you’re saying. We’re very prepared.

Is a local portfolio manager really better than a portfolio manager in New York City?

TC: I think so. All the action around state municipal bonds is in the state. Our in-state portfolio managers know the issues way beyond what someone in Manhattan could possibly know. They’ve got access to the local markets and they know the legislation.

How are local trustees important to the funds?

TC: Among the board members, we often have representatives with prior experience in local government. The former Kentucky state budget director for many years, Dr. James Ramsey, is a board member. He knows many of those municipal bond issues inside and out. That’s unique, and makes for strong quality control.

JG: Shareholders are reassured when they attend a shareholder or outreach meeting and they know the trustees. Or they’ve heard about us in the local media.

JL: I’ll see people I’ve known for 20 years at these meetings. That relationship and my investments in the funds are additional incentives in fulfilling this role.

JG: We oversee the analysis of holdings in the funds. We’re aware of the risks and the capacity of the issuers to pay on the bonds. In times of investor fear about municipals, for example when Puerto Rico and Detroit have been in the news, this oversight can be reassuring to shareholders.

You’ve all been trustees for 20 years or more. What has changed the most?

JG: Governmental and regulatory oversight has increased exponentially. That puts a premium on the independence and strength of vision of each board. Take the nominating process. This involves an independent search for people with experience, integrity, and background—people who will contribute as independent trustees. The quality of boards is enhanced by the process.

Another change is the quality of legal, accounting, and other service providers to the funds. It’s a much more sophisticated, demanding environment.

JL: You want to be at the forefront of change, not dragged into it. We’ve made a real effort to be up-to-speed on regulatory, legal, and financial issues.

TC: The most positive change I’ve seen in the last couple of years is the chief compliance officer (CCO) function. He reports directly to the boards, and we ask him very pointed questions about potential risks. Again, we’re looking at matters from the perspective of shareholders. We hired the CCO, and he reports ultimately to us.   In fact, we approve a portion of his salary in order to reinforce that alignment.  That’s a major change.

He’s the watchdog’s watchdog?

TC: Yes!

JL: That due diligence Tom and Jim describe is something that financial advisers and shareholders may not be familiar with. It’s very important and we devote a lot of time to meeting with the CCO.

TC: The focus on the CCO role, including the CCO’s relationship with the board, was greatly enhanced about a decade ago—it’s a good, healthy thing for shareholders.

Who else assists with your watchdog role?

JG: Our legal counsel.  Tom and I chaired the legal succession committee, which was created to address the reality that, several years ago, a number of lawyers with the law firm that represented both the funds and the independent trustees were about to retire. The succession process took a year. We reached out to the best law firms in the country and scrutinized their expertise, commitment, fee structure. As a result, we’ve hired what we believe to be some of the nation’s best lawyers specializing in the fund industry. This process involved all the trustees of each board, was carefully deliberated, and by consensus we got a really good result.

Let’s say something goes wrong in the operation of a fund. What’s your role as trustees?

TC:  Again, we represent the shareholders. If an error were to occur, we would seek to understand the cause, how the error was made, and who would pay to get the error corrected if there were a cost involved. We wouldn’t allow shareholders to foot the bill.  And, we would expect the responsible party to put steps in place to make sure it doesn’t happen again.

Do you meet quarterly?

TC: We meet quarterly in person. We have many phone meetings throughout the year, as needed. If an important matter comes up, we’ll meet. We act immediately.

JL: I’ve been on a conference call from southwest Africa. We also meet by phone—for example, before our quarterly in-person meetings—so we’re better prepared.

TC: Hurricane Sandy is a good example. As Sandy was about to hit, we were on the phone—ensuring that appropriate safeguards were in place and being implemented, and determining how our systems would function in the midst of the crisis. There was constant contact.

What will you accomplish in today’s meetings?

JG: It’s a big weekend. It’s the annual contract renewals for advisers and sub-advisers. This comes after intensive scrutiny—we hired independent consultants to look at our advisers’ performance, expense ratios, and profitability. They did superb work.

TC: I’m on a subcommittee that reviews the adviser’s financial statements in thorough detail. I’ll report tomorrow on our analysis. We want to make sure that our adviser is financially sound.

JL: Before arriving here, we read a number of documents, one 567 pages and another 205 pages. We’re expected to voice any issues we come across.

JG: The expectation is that everyone will have read the materials and will participate in the meeting. After thorough discussion and consideration, we will ask legal counsel whether there is anything else we should consider.

What’s really important about these meetings is the insight around the table. We’ve got the experience and the sophistication to dig into the substantive issues.

TC: Right—everyone has a specialty. I don’t try to analyze the economy; I let John do that. If it’s an accounting issue, they look to me.

We did this before it was required by the SEC—just the independent board members, spending a few hours together before the full board meeting. We’ll call in the CCO, the CFO, the auditors as needed—all independently and without Aquila management present. Everything is handled at arm’s length to make sure that the independence is there and that we know the full story. At the end of the day, it’s for the shareholders.

JG: While the SEC was deciding whether to require a greater level of board independence, we went ahead and did it.

JL: We also go through a process of assessing the board every year to, among other things, make sure the trustees feel they’re getting what they need to do their jobs.

It sounds like a lot of work. What do you enjoy about being a trustee?

JG: Other trustees. Their different backgrounds, the seriousness with which they do their jobs.

JL: Exactly. I enjoy the association.

TC: Ditto. And regarding backgrounds, I think it’s critical in the mutual fund business to have experienced, knowledgeable trustees. This is a difficult industry to get your arms around. Very few people know how funds get distributed, or how the landscape and the rules change. It’s important to have a seasoned, experienced group of trustees. People like Dr. Ramsey.

JL: And Gary Cornia, who’s done research on municipal bonds.

JG: Or on the Oregon board, Ed Jensen, the former COO of US Bancorp; Ralph Shaw, who served as Chairman of Governor’s Council of Economic Advisors of State of Oregon; and John Mitchell, a leading economist in the northwest U.S.

JL: And Lyle Hillyard, who is a Utah state senator.

Tell us what accomplishments you’re most proud of as trustees?

TC: Cutting expenses for shareholders’ benefit. And, restructuring various funds into separate series of one trust. This project was designed to result in efficiencies in the administration and oversight of the funds for the ultimate benefit of the shareholders.  And, shareholders should experience additional savings.

JL: Restructuring the funds has taken the longest amount of time and the most dogged determination to get accomplished. And it’s our most significant accomplishment.

JG: I’m proudest of the quality of the people we’ve been able to attract and retain on the Oregon board. That, and a quarter century of clean audits.

What are your biggest goals for the next few years?

TC: To replace knowledgeable trustees as they retire in line with our retirement policy with competent, experienced trustees. It’s challenging.

JL: We’re going to see more change in this industry, and we need to make sure we’re prepared—to be aware of what’s changing and determine how best to react. I don’t think the change will be revolutionary, but it’s going to be evolutionary, at a pace that’s going to keep us busy.

JG: The nominating process is a challenge and really important for the future. Finding the right experience, expertise—and then, on top of that, the diversity, youth, geographical representation.

Another challenge is how the boards relate to each other. Bringing them together, but in a way that still respects each board’s legal autonomy and fiduciary duty. It sounds abstract but it’s a big challenge and a big opportunity.

What has Lacy’s legacy been on the organization?

TC: Lacy was innovative and definitely ahead of his time on a lot of things. And Diana Herrmann has significantly improved the organization in the last five years. She’s doing an excellent job of moving Aquila forward as a fund family, and as a member of the individual boards that we all serve on. I think Aquila has the highest level of true professionals on its staff today relative to any time in its history.

So my compliments are to Diana. Like her father, she’s doing the right things for the right reasons, and it’s all in the shareholders’ interests. I want to be on the board that has that attitude, and with an adviser who shares that attitude.

JG: I agree—and the board has had a role there, too. Lacy’s legacy is real, vital, and central to the firm. But the boards’ innovations and changes have also been very valuable to shareholders and the organization.

Aquila is maturing, in cadence with what’s going on in the economic, regulatory, and legal environments. And the trustees have been innovative the whole way.