WALL STREET GIBBERISH, 2005 FIRST QUARTER NEWSLETTER

In the last issue, the example was the purported "independence" of opinions given by banks or other parties that had a vested interest in the outcome of proposed deals. This time there are two more examples of supposed independence that really is not so.

The first results from a new disclosure buried in a statement of additional information that is available in conjunction with mutual fund prospectuses. A Wall Street Journal article on January 31 reports that Fidelity makes payments to many of the firms that sell its mutual funds, including large brokerage houses, that may be "significant" although no specific dollar amounts are disclosed. By itself, that is not all that bad as mutual funds often pay for marketing services.

The troublesome disclosure is that the amount of the payments will depend on whether or not Fidelity’s funds are placed on special lists that are typically billed as "preferred" or "recommended." Brokerage firms that have such lists would like you to believe that they have independently chosen mutual funds that they think are well suited for particular investment objectives. However, the Fidelity disclosure reveals that they are better described as paid advertising. The article only mentions Fidelity, but I would be surprised if many other mutual fund companies did not have similar payments to brokers. As always, one is advised to read brokerage house pronouncements with a goodly amount of sodium chloride in hand.

The second example comes from Warren Buffett’s letter to Berkshire Hathaway stock owners, which was discussed in the Perspective section, concerning independent members of corporate boards of directors. Those are members who are not employees of the company or otherwise involved in management and operations. Regulations require that the boards have independent members, particularly to serve on executive compensation and audit committees. Buffett is an independent director of many corporations; I think something like 23.

In the letter he points out that there are some who may not really be independent. In a sense, very few are truly independent because virtually all "elections" are really ratifications of management’s slates. However, there are some whose primary income comes from serving as independent directors. They may not want to upset management so they won’t be retained and lose that income. Moreover, they may hope to be recommended for other boards in order to increase income.

Buffett thinks most of these directors do a good job and put the stock owners’ interests first. However, that is not always the case. He says, without naming any names, he has "first-hand knowledge" of a takeover proposal (not by Berkshire) that was favored by management and was at a higher price than the stock had seen for years and which still has not been reached. Some of the directors favored the proposed acquisition and wanted it presented to shareholders. He claims that several of the board members, each of whom was paid about $100,000 a year for their services, managed to scuttle the proposal, and it was never brought to the attention of the stock owners. These directors did not own much stock, so any gains from selling would have been small in comparison to losing a nice source of income.

Buffett admits he does not know what motivated those who opposed the transaction. However, it is interesting and ironic that at the meeting when the deal was rejected "the board voted itself a significant increase in directors’ fees."

These examples show that the concept of being independent when passed through Wall Street hands may be turned into gibberish. When that happens, it is usually the ordinary investor who pays the price.

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