[Federal Register: August 2, 2004 (Volume 69, Number 147)]
[Rules and Regulations]
[Page 46377-46393]
From the Federal Register Online via GPO Access [wais.access.gpo.gov]
[DOCID:fr02au04-11]
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Part IV
Securities and Exchange Commission
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17 CFR Part 270
Investment Company Governance; Final Rule
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SECURITIES AND EXCHANGE COMMISSION
17 CFR Part 270
[Release No. IC-26520; File No. S7-03-04]
RIN 3235-AJ05
Investment Company Governance
AGENCY: Securities and Exchange Commission.
ACTION: Final rule.
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SUMMARY: The Securities and Exchange Commission (``Commission'') is
adopting amendments to rules under the Investment Company Act of 1940
to require investment companies (``funds'') that rely on certain
exemptive rules to adopt certain governance practices. The amendments
are designed to enhance the independence and effectiveness of fund
boards and to improve their ability to protect the interests of the
funds and fund shareholders they serve.
DATES: Effective date: September 7, 2004.
Compliance date: January 16, 2006.
FOR FURTHER INFORMATION CONTACT: Catherine E. Marshall, Attorney,
Office of Investment Adviser Regulation, (202) 942-0719; C. Hunter
Jones, Assistant Director, Office of Regulatory Policy, (202) 942-0690,
Division of Investment Management, Securities and Exchange Commission,
450 Fifth St., NW, Washington, DC 20549-0506.
SUPPLEMENTARY INFORMATION: The Commission is adopting amendments to:
rules 0-1(a) [17 CFR 270.0-1(a)]; 10f-3 [17 CFR 270.10f-3]; 12b-1(c)
[17 CFR 270.12b-1(c)]; 15a-4(b)(2) [17 CFR 270.15a-4(b)(2)]; 17a-7(f)
[17 CFR 270.17a-7(f)]; 17a-8(a)(4) [17 CFR 270.17a-8(a)(4)]; 17d-
1(d)(7) [17 CFR 270.17d-1(d)(7)]; 17e-1(c) [17 CFR 270.17e-1(c)]; 17g-
1(j)(3) [17 CFR 270.17g-1(j)(3)]; 18f-3(e) [17 CFR 270.18f-3(e)]; 23c-
3(b)(8) [17 CFR 270.23c-3(b)(8)]; and 31a-2 [17 CFR 270.31a-2] under
the Investment Company Act of 1940 [15 U.S.C. 80a] (the ``Investment
Company Act'' or the ``Act'').\1\
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\1\ Unless Otherwise noted, all references to statutory sections
are to the Investment Company act of 1940.
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Table of Contents
I. Background
II. The Role of Independent Directors
A. Managing Conflicts of Interest
B. Approving the Advisory Contract and Advisory Fees
C. Selecting and Nominating Candidates for Independent Directors
III. Discussion of New Rules
A. Board Composition
B. Independent Chairman of the Board
C. Annual Self-Assessment
D. Separate Sessions
E. Independent Director Staff
F. Recordkeeping for Approval of Advisory Contracts
IV. Effective Date; Compliance Date
V. Paperwork Reduction Act
VI. Cost-Benefit Analysis
VII. Final Regulatory Flexibility Analysis
VIII. Consideration of Promotion of Efficiency, Competition and
Capital Formation
Statutory Authority
Text of Rules
I. Background
In January 2004, the Commission proposed amendments to improve the
governance standards of investment companies (i.e., funds).\2\ These
amendments provide for greater independence of fund boards in the case
of funds that rely upon certain exemptive rules that allow funds to
engage in transactions that would otherwise be prohibited under the
Investment Company Act and that present conflicts of interest between
the fund and its management company. These amendments expand upon the
fund governance amendments we adopted in 2001, which require that any
fund that relies upon those exemptive rules must have a governance
structure that provides, among other things, for a board that has a
majority of independent directors.\3\ In light of recent developments,
we now believe that the 2001 amendments do not go far enough in
addressing the need for independent fund boards.\4\
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\2\ Investment Company Governance, Investment Company Act
Release No. 26323 (Jan. 15, 2004) [69 FR 3472 (Jan. 23, 2004)]
(``Proposing Release''). In 2001, we adopted amendments that require
any fund that relies upon certain exemptive rules to have (i) a
board that has a majority of independent directors; (ii) the
independent directors select and nominate independent directors; and
(iii) independent directors, if they hire counsel, hire only counsel
that does not have substantial ties to fund managers. Role of
Independent Directors of Investment Companies, Investment Company
Act Release No. 24816 (Jan. 2, 2001) [66 FR 3734 (Jan. 16, 2001)]
(``2001 Adopting Release'').
\3\ In this Release we are using ``independent director'' to
refer to a director who is not an ``interested person'' of the fund,
as defined by the Act. See infra note 23.
\4\ As one commenter on the proposal noted, ``The current
requirement for a bare majority of independent directors does not
adequately assure that these directors will dominate the decision-
making process.'' Letter from Consumer Federation of America, et
al., to Jonathan G. Katz, Secretary, SEC (Mar. 10, 2004), File No.
S7-03-04 (``Consumer Federation Letter'').
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We proposed these rule amendments, along with a number of other
initiatives,\5\ in the wake of a troubling series of enforcement
actions involving late trading of mutual fund shares, inappropriate
market timing activities, and misuse of nonpublic information about
fund portfolios.\6\ When we
[[Page 46379]]
proposed these amendments, we expressed concern that the enforcement
actions in many cases reflected a serious breakdown in management
controls. We observed that, in some cases, the fund was used for the
benefit of fund insiders, often the management company or its
employees. In addition, we had recently adopted a new rule creating the
position of fund chief compliance officer, which reports directly to
the board on compliance matters.\7\ The proposed fund governance
standards would complement that rule by placing fund boards in a better
position to demand that management adhere to the highest of compliance
standards.
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\5\ See, e.g., Disclosure Regarding Approval of Investment
Advisory Contracts by Directors of Investment Companies, Investment
Company Act Release No. 26350 (Feb. 11, 2004) [69 FR 7852 (Feb. 19,
2004)] (proposing release) and 26486 (June 23, 2004) [69 FR 39798
(June 30, 2004)] (adopting release); Investment Adviser Codes of
Ethics, Investment Company Act Release No. 26337 (Jan. 20, 2004) [69
FR 4040 (Jan. 27, 2004)] (proposing release) and 26492 (July 2,
2004) [69 FR 41696 (July 9, 2004)] (adopting release); Disclosure of
Breakpoint Discounts by Mutual Funds, Investment Company Act Release
Nos. 26298 (Dec. 17, 2003) [68 FR 74732 (Dec. 24, 2003)] (proposing
release) and 26464 (June 7, 2004) [69 FR 33262 (June 14, 2004)]
(adopting release) (``Breakpoint Disclosure''); Disclosure Regarding
Market Timing and Selective Disclosure of Portfolio Holdings,
Investment Company Act Release Nos. 26287 (Dec. 11, 2003) [68 FR
70402 (Dec. 17, 2003)] (proposing release) and 26418 (Apr. 19, 2004)
[69 FR 22300 (Apr. 23, 2004)] (adopting release) (``Market Timing
Disclosure''); Mandatory Redemption Fees for Redeemable Fund
Securities, Investment Company Act Release No. 26375A (Mar. 5, 2004)
[69 FR 11762 (Mar. 11, 2004)]; Prohibition on the Use of Brokerage
Commissions to Finance Distribution, Investment Company Act Release
No. 26356 (Feb. 24, 2004) [69 FR 9726 (Mar. 1, 2004)]; Amendments to
Rules Governing Pricing of Mutual Fund Shares, Investment Company
Act Release No. 26288 (Dec. 11, 2003) [68 FR 70388 (Dec. 17. 2003)].
\6\ See, e.g., In the Matter of Alliance Capital Management,
L.P., Investment Company Act Release No. 26312A (Jan. 15, 2004)
(finding that an investment adviser violated its fiduciary duty to
the fund by failing to disclose agreements, and making special
accommodations, to permit select investors to engage in market
timing transactions in exchange for the maintenance of ``sticky
assets,'' and finding that the investment adviser divulged material
nonpublic information about portfolio holdings); In the Matter of
Putnam Investment Management, LLC, Investment Company Act Release
No. 26255 (Nov. 13, 2003) (finding that an investment adviser failed
to disclose potentially self-dealing transactions in shares of funds
managed by several of its employees, failed to have procedures
reasonably designed to prevent misuse of material nonpublic
information, and failed to reasonably supervise the employees who
committed violations); In the Matter of James Patrick Connelly Jr.,
Investment Company Act Release No. 26209 (Oct. 16, 2003) (finding
that a former executive of an investment adviser to a fund complex
approved agreements that permitted select investors to engage in
market timing transactions in certain funds in the complex, in
exchange for the maintenance of sticky assets); In the Matter of
Steven B. Markovitz, Investment Company Act Release No. 26201 (Oct.
2, 2003) (finding that a former hedge fund trader violated the
federal securities laws and defrauded investors by engaging in late
trading of mutual fund shares). See also In the Matter of Pilgrim
Baxter & Associates, Ltd., Investment Company Act Release No. 26470
(June 21, 2004) (finding that the investment adviser violated the
federal securities laws by failing to disclose to funds' board of
directors or shareholder that its principal was engaged in self-
dealing transactions through significant ownership stake in a hedge
fund engaged in market timing of fund managed by him, by permitting
market timing despite prospectus disclosure to the contrary, and by
disclosing material nonpublic portfolio information to a broker-
dealer whose customers engaged in market timing the funds); In the
Matter of Strong Capital Management, Inc., Investment Company Act
Release No. 26409 (May 20, 2004) (finding that investment adviser
violated its fiduciary duties to the funds by (i) failing to
disclose to the funds' boards or shareholders the conflicts of
interest created when the adviser allowed hedge fund to market time
certain funds and that the chairman frequently traded certain funds,
including a fund for which he served as portfolio manager, (ii)
providing hedge fund manager nonpublic portfolio information for
certain funds, and (iii) filing fund prospectuses that failed to
disclose that the adviser would make exceptions to the disclosed
policies discouraging market timing in instances where the fund's
chairman or the adviser benefited); In the Matter of Massachusetts
Financial Services Company, Investment Company Act Release No. 26409
(Mar. 31, 2004) (sanctioning fund investment adviser for failing to
disclose to the fund board that the adviser had entered into
arrangements with approximately 100 broker-dealers under which the
fund adviser agreed to make certain cash payments or direct fund
brokerage to certain broker-dealers in return for preferred
treatment in promoting fund sales).
\7\ Compliance Programs of Investment Companies and Investment
Advisers, Investment Company Act Release No. 26299 (Dec. 17, 2003)
[68 FR 74714 (Dec. 24, 2003)] (``Compliance Programs'').
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Our proposed rules also reflected broader concerns with the
governance of mutual funds. We noted that the Act and our rules rely
heavily on fund boards of directors to manage the conflicts of interest
that advisers have with funds they manage. We noted that a fund adviser
is frequently in a position to dominate the board because of the
adviser's monopoly over information about the fund and its frequent
ability to control the board's agenda. We questioned the ability of a
management-dominated board to undertake the many important tasks
assigned to the board by the Act and our rules, including negotiating
the advisory fee, approving a 12b-1 plan, and resolving conflicts
between the fund and the management company.\8\
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\8\ Directors are generally responsible under state law for the
oversight of all of the operations of a mutual fund, and the
Investment Company Act assigns many specific responsibilities to
fund boards. For example, fund boards must evaluate and approve a
fund's advisory contract and may unilaterally terminate the
contract. See section 15 of the Act [15 U.S.C. 80a-15].
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We proposed to amend ten commonly used exemptive rules under the
Investment Company Act (``Exemptive Rules'') \9\ to require the funds
relying on those rules to follow improved governance standards.\10\
These rules rely on the independent judgment and scrutiny of directors,
including independent directors, in overseeing activities that are
beneficial to funds and fund shareholders but that involve inherent
conflicts of interest between the funds and their managers. These are
the same Exemptive Rules that we amended in 2001. These further
amendments provide for greater fund board independence and are designed
to enhance the ability of fund boards to perform their important
responsibilities under each of the rules.\11\
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\9\ The Exemptive Rules are:
Rule 10f-3 (permitting a fund to purchase securities in a
primary offering when an affiliated broker-dealer is a member of the
underwriting syndicate, if the fund directors, including a majority
of the independent directors, approve procedures governing the
purchases and review quarterly reports on purchases);
Rule 12b-1 (permitting use of fund assets to pay distribution
expenses pursuant to a plan approved by the fund directors,
including a majority of the independent directors);
Rule 15a-4(b)(2) (permitting a fund board to approve an interim
advisory contract without shareholder approval when the adviser or a
controlling person receives a benefit in connection with the
assignment of the contract, if the fund directors, including a
majority of the independent directors, review and approve the
contract);
Rule 17a-7 (permitting securities transactions between a fund
and another client of the fund investment adviser, if the fund
directors, including a majority of the independent directors,
approve procedures governing the transactions and review quarterly
reports on transactions);
Rule 17a-8 (permitting mergers between certain affiliated funds
if the fund directors, including a majority of the independent
directors, request and evaluate information about the merger and
determine that the merger is in the best interests of the fund and
its shareholders);
Rule 17d-1(d)(7) (permitting a fund and its affiliates to
purchase joint liability insurance policies if the fund directors,
including a majority of the independent directors, annually
determine that the policies are in the best interests of the fund
and its shareholders);
Rule 17e-1 (specifying conditions under which a fund may pay
commissions to affiliated brokers in connection with the sale of
securities on an exchange, including a requirement that the fund
directors, including a majority of the independent directors, adopt
procedures for the payment of the commissions and review quarterly
reports of any commissions paid);
Rule 17g-1 (permitting a fund to maintain joint insured bonds
and requiring fund independent directors to annually approve the
bond);
Rule 18f-3 (permitting a fund to issue multiple classes of
voting stock, if the fund board of directors, including a majority
of the independent directors, approves a plan for allocating
expenses to each class); and
Rule 23c-3 (permitting the operation of an interval fund by
enabling a closed-end fund to repurchase shares from investors, if
the directors adopt a repurchase policy for the fund and review fund
operations and portfolio management in order to assure adequate
liquidity of investments to satisfy repurchase payments).
Last October we proposed a new exemptive rule, rule 15a-5, that
also would be conditioned on meeting the fund governance standards
that are currently included in these ten exemptive rules. See
Exemption from Shareholder Approval for Certain Subadvisory
Contracts, Investment Company Act Release No. 26230 (Oct. 23, 2003)
[68 FR 61720 (Oct. 29, 2003)]. As we stated when we proposed the
fund governance amendments we are adopting today, if we adopt rule
15a-5, we intend to condition its use on compliance with the revised
fund governance standards. See Proposing Release, supra note 2, at
n.16.
\10\ These rules (i) exempt funds or their affiliated persons
from provisions of the Act that can involve serious conflicts of
interest and (ii) condition the exemptive relief on the approval or
oversight of independent directors. See Proposing Release, supra
note 2, at text accompanying n.16.
\11\ For the reasons discussed throughout this Release, we
believe that amending the Exemptive Rules to provide for greater
board independence and to enhance a board's ability to perform the
responsibilities under those rules is necessary and appropriate in
the public interest and is consistent with the protection of
investors and the purposes of the Act. See, e.g., section 6(c)
(authority of the Commission to conditionally exempt a person or
transaction if it is ``necessary or appropriate in the public
interest and consistent with the protection of investors and the
purposes fairly intended by the policy and provisions of this
title.''). Each of the Exemptive Rules permits a fund to engage in
transactions or conduct that presents significant conflicts of
interest and that otherwise would be restricted or prohibited by the
Act. As the Commission already determined when it made similar
amendments to the Exemptive Rules in 2001, establishing conditions
for the Exemptive Rules based on the independence of the fund board
is appropriate to address the types of conflicts Congress identified
in the Act. The amendments therefore are well within the
Commission's broad authority to ``conditionally or unconditionally
exempt any person, security, or transaction'' from any provision of
the Act. See also infra Statutory Authority section.
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The proposal engendered a substantial amount of interest. We
received nearly 200 comments from fund investors, management companies,
independent directors to mutual funds, as well as members of Congress.
We also received several comments from organizations that had a more
general interest in corporate governance issues. Most commenters
supported our efforts to strengthen fund governance, but many were
divided on some of our proposals. Some commenters believed the proposed
amendments did not go far enough; others recommended certain
modifications.
We recognize that these amendments might not have prevented all of
the abuses that were uncovered in the enforcement actions discussed
above. Nevertheless, if funds are to engage in the transactions
permitted by the Exemptive Rules \12\ and effectively
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manage the conflicts of interest inherent in those transactions,
greater board independence is needed. We are adopting them
substantially as proposed.
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\12\ As we stated when we proposed the fund governance
amendments that we adopted in 2001, the amended rules do not require
all funds to adopt these measures. Although the Commission urges all
funds to consider adopting the measures to strengthen the
independence of their boards, funds that do not rely on any of the
Exemptive Rules will not be subject to these requirements. See Role
of Independent Directors of Investment Companies, Investment Company
Act Release No. 24082 (Oct. 14, 1999) [64 FR 59826 (Nov. 3, 1999)]
(``1999 Proposing Release'') at text preceding n.34.
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II. The Role of Independent Directors
Before we discuss the rules we are today adopting, we wish to take
this opportunity to make some observations about the role of fund
directors and, in particular, independent directors.
A. Managing Conflicts of Interest
Fund independent directors play a central role in policing the
conflicts of interest that advisers inevitably have with the funds they
advise. Many fine individuals today ably serve investors in this
capacity. We do not intend that this rulemaking, or the statements we
have made about the need for reform of the mutual fund regulatory
framework or mutual fund governance, be construed in any way as a
challenge to their integrity or commitment to investors. Our efforts
today are designed to strengthen the role that independent directors
play and to support their work on behalf of fund shareholders. The
amendments are intended largely to preserve the current system of fund
governance that on the whole has served mutual fund investors well,
while addressing its weaknesses.
To be truly effective, a fund board must be an independent force in
fund affairs rather than a passive affiliate of management.\13\ Its
independent directors must bring to the boardroom ``a high degree of
rigor and skeptical objectivity to the evaluation of management and its
plans and proposals,'' particularly when evaluating conflicts of
interest.\14\ They must commit their time and energy, and devote
themselves to the principles set forth in the Investment Company Act
and state corporate and trust law under which the fund is organized.
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\13\ See Division of Corporation Finance, Securities and
Exchange Commission, Staff Report on Corporate Accountability (Sept.
4, 1980) (printed for the use of Senate Committee on Banking,
Housing, and Urban Affairs, 96th Cong., 2d Sess.) at F2 (noting
importance of corporate boards of directors in overseeing
performance of corporate management).
\14\ Donald C. Langevoort, The Human Nature of Corporate Boards:
Law, Norms, and the Unintended Consequences of Independence and
Accountability, 89 Geo. L. J. 797, 798 (2001). ``[T]here are
industries where the case for independence is compelling. The best
example here is the mutual fund industry, where conflicts of
interests are commonplace and traditional checks on managerial
overreaching, such as vigorous shareholder voting and hostile tender
offers do not exist.'' Id. at 814.
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While the Investment Company Act contains many important
requirements with which a fund must comply, the paramount principle
that must prevail, and should animate all decisions directors are
called upon to make, is that a fund must be managed on behalf of its
investors rather than on behalf of the adviser or other affiliated
persons of the fund.\15\ Directors should be highly skeptical of
arguments that merely rationalize the resolution of conflicts in favor
of the fund adviser, and should seek results that advance the best
interest of fund shareholders.
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\15\ Section 1(b)(2) of the Act [15 U.S.C. 80a-1(b)(2)] (``[T]he
national public interest and the interest of investors are adversely
affected * * * (2) when investment companies are organized,
operated, managed, or their portfolio securities are selected, in
the interest of directors, officers, investment advisers,
depositors, or other affiliated persons thereof, in the interest of
underwriters, brokers, or dealers, in the interest of special
classes of their security holders, or in the interest of other
investment companies or persons engaged in other lines of business,
rather than in the interest of all classes of such companies'
security holders * * * '').
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B. Approving the Advisory Contract and Advisory Fees
Section 15(c) of the Act prohibits a person from serving as an
investment adviser to a fund except pursuant to a contract that has
been approved by a majority of directors who are not parties to the
contract or interested persons of any such party, i.e., the independent
directors. Section 15(c) requires fund boards to consider whether to
approve the terms of the contract, including the amount of the advisory
fee based on, among other things, information provided by the fund
adviser. These procedural requirements do not supplant the state law
duties of loyalty and care that oblige directors to act in the best
interest of the fund when considering important matters the Act
entrusts to them, such as approval of an advisory contract and the
advisory fee.\16\ Nor does the disclosure of the advisory fee in the
prospectus relieve the independent directors of the obligation to
negotiate the amount of the fee and assure that fund shareholders share
in the economies of scale achieved by the growth in fund assets, by,
when appropriate, reducing advisory fees.\17\
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\16\ See S. Rep. No. 91-184, at 4902-03 (1969) (``The directors
of a mutual fund, like directors of any other corporation, will
continue to have * * * overall fiduciary duties as directors for the
supervision of all of the affairs of the fund.''); Burks v. Lasker,
441 U.S. 471, 478-79 (1979) (``The [Investment Company Act] does not
purport to be the source of authority for managerial power; rather,
the Act functions primarily to `[impose] controls and restrictions
on the internal management of investment companies.' * * * The ICA
and the [Investment Advisers Act] * * * do not require that federal
law displace state laws governing the powers of directors unless the
state laws permit action prohibited by the Acts, or unless `their
application would be inconsistent with the federal policy underlying
the cause of action' * * *.'') (emphasis in original) (citations
omitted). See also Green v. Fund Asset Management, L.P., 245 F.3d
214, 226 (3d Cir. 2001).
\17\ See Stanley J. Friedman, The Role of Outside Directors in
Negotiating Investment Company Advisory Agreements, 24 Rev. Sec. &
Commod. Reg. 49, 57 (1991) (``[T]he negotiation of investment
advisory agreements and renewals is a [serious] business in which
the participation of independent directors who are `qualified, fully
informed, and * * * conscientious' will not only benefit the
investment company and its shareholders but will also greatly
enhance the position of the investment adviser in litigation.'');
American Bar Association, Fund Director's Guidebook, 59 Bus. Law.
201, 223 (2003) (``The 1940 Act contains important provisions
governing the relationship between the adviser and the fund's board
of directors in negotiating an advisory contract.'') (emphasis
added); David A. Sturms, Mutual Fund Regulation, Part III:
Regulation of the Adviser and the Fund Portfolio, PLIREF-MFR Sec.
6:7 (2002) (``[T]he 1940 Act sets forth a specific framework for
governing the relationship between the adviser and the fund's board
of directors in negotiating an advisory contract.'') (emphasis
added); Review of Current Investigations and Regulatory Actions
Regarding the Mutual Fund Industry: Fund Operations And Governance:
Hearings before the Senate Committee on Banking, Housing, and Urban
Affairs, 108th Cong., 2d Sess., 7-8 (Feb. 26, 2004) (statement of
David S. Ruder, Professor, Northwestern University School of Law
(``[Fund directors] must bargain with the adviser regarding the
costs of its services * * *'')) (http://banking.senate.gov/files/ruder.pdf
). See also Schuyt v. Rowe Price Prime Reserve Fund, Inc.,
663 F. Supp. 962, 986 (S.D.N.Y. 1987) (``This is not a case where a
contract was rubber-stamped by docile individuals; this is a case
where competent, aggressive individuals analyzed the facts and
actively bargained to obtain a better deal for the Fund.'')
(emphasis added); SEC, Public Policy Implications of Investment
Company Growth, reprinted in H.R. Rep. No. 89-2337, at 127 (1966)
(``Advisory Fees and the Limitations of Disclosure'').
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Section 15(c) also provides that the directors of a fund have a
duty to request and evaluate, and the investment adviser has a duty to
furnish, the information reasonably necessary to evaluate the terms of
an advisory contract. Directors should frame their information requests
broadly to obtain complete information relevant to their consideration
of the advisory contract, and should include inquiries related to the
adviser's material conflicts of interest with the fund and how the
adviser deals with those conflicts. Regardless of the scope of the
information request, fund advisers have an affirmative obligation under
section 206 of the Advisers Act to disclose material information
regarding conflicts of interest to the fund and its board.\18\
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\18\ 15 U.S.C. 80b-6. See SEC v. Capital Gains Research Bureau,
Inc., 375 U.S. 180, 201 (1963) (noting that an investment adviser
may not trade on the market effect of his recommendations without
``fully and fairly revealing his personal interests in these
recommendations to his clients''); Vernazza v. SEC, 327 F.3d. 851,
860 (9th Cir. 2003) (noting that investment advisers had a duty to
disclose any potential conflicts of interest accurately and
completely). See also In the Matter of Putnam Investment Management,
LLC, supra note 6.
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We reiterate our statement in the Proposing Release that fund
[[Page 46381]]
shareholders stand to benefit substantially when the process of
negotiation between fund independent directors and investment advisers
leads to lower fees.\19\ We reaffirm the views we expressed in a
statement accompanying a recently settled enforcement proceeding, that
the best way to ensure that funds obtain fair and reasonable fees is
through a marketplace of vigorous, independent and diligent mutual fund
boards, coupled with fully informed investors who are armed with
complete, easy-to-digest disclosure about the fees paid and the
services rendered.\20\ We have recently adopted and proposed new
disclosure requirements designed to provide fund investors with this
information.\21\
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\19\ Proposing Release, supra note 2, at n.30 and accompanying
text.
\20\ See Statement of the Commission Regarding the Enforcement
Action Against Alliance Capital Management, L.P., SEC Press Release
2003-176 (Dec. 18, 2003).
\21\ See, e.g., Market Timing Disclosure, supra note 5;
Breakpoint Disclosure, supra note 5; Shareholder Reports and
Quarterly Portfolio Disclosure of Registered Management Investment
Companies, Investment Company Act Release No. 26372 (Feb. 27, 2004)
[69 FR 11244 (Mar. 9, 2004)]; Confirmation Requirements and Point of
Sale Disclosure Requirements for Transactions in Certain Mutual
Funds and Other Securities, and Other Confirmation Requirement
Amendments, and Amendments to the Registration Form for Mutual
Funds, Investment Company Act Release No. 26341 (Jan. 29, 2004) [69
FR 6438 (Feb. 10, 2004)]; Fund of Funds Investments, Investment
Company Act Release No. 26198 (Oct. 1, 2003) [68 FR 58226 (Oct. 8,
2003)].
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C. Selecting and Nominating Candidates for Independent Directors
The incumbent independent directors of most funds have the
responsibility to select and nominate new independent directors.\22\
The Investment Company Act provides minimum criteria for persons to
qualify as independent directors, and independent directors who satisfy
those criteria meet the requirements of the Act.\23\ We urge
independent directors to look beyond those requirements and examine
whether a candidate's personal or business relationships suggest that
the candidate will not aggressively represent the interests of fund
investors. Persons who have served as executives of the fund adviser or
who are close family members of employees of the fund, its adviser or
principal underwriter would, in our view, be poor choices for
candidates, although they may meet the minimum statutory
requirements.\24\ We recognize that ``legal'' independence does not
equate with ``real'' independence. We therefore encourage independent
directors, in selecting and nominating other independent directors, to
identify individuals who have the background, experience, and
independent judgment to represent the interests of fund investors.\25\
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\22\ As in effect before these amendments, the Exemptive Rules
have required that, for any fund relying on any of the rules, the
independent directors must select and nominate other independent
directors of the fund. See, e.g., rule 10f-3(c)(11)(i) [17 CFR
270.10f-3(c)(11)(i)]. Before we proposed to amend the Exemptive
Rules in 1999, we had already included a similar condition in rule
12b-1 and rule 23c-3. See Bearing of Distribution Expenses by Mutual
Funds, Investment Company Act Release No. 11414 (Oct. 28, 1980) [45
FR 73898 (Nov. 7, 1980)]; Repurchase Offers By Closed-End Management
Investment Companies, Investment Company Act Release No. 19399 (Apr.
7, 1993) [58 FR 19330 (Apr. 14, 1993)]. See also 1999 Proposing
Release, supra note 11, at n.30.
\23\ In this Release we are using ``independent director'' to
refer to a director who is not an ``interested person'' of the fund,
as defined by the Act. Section 2(a)(19) of the Act [15 U.S.C. 80a-
2(a)(19)] defines ``interested person'' of a fund to include (i) any
affiliated person of the fund; (ii) any member of the immediate
family of any natural person who is an affiliated person of the
fund; (iii) any interested person of any investment adviser of or
principal underwriter for the fund; (iv) any person, or partner or
employee of any person, who acted as legal counsel for the fund
during the last two completed fiscal years of the fund; (v) any
person who executed portfolio transactions for the fund or loaned
money or property to the fund during the past six months, or any
affiliated person of such a person; and (vi) any natural person who
the Commission has determined is an interested person because of his
or her material business or professional relationship with the fund
during the past two years.
\24\ See Investment Company Institute, Report of the Advisory
Group on Best Practices for Fund Directors: Enhancing A Culture of
Independence and Effectiveness (June 24, 1999), at 12-13 (``ICI
Advisory Group Report'') (recommending that former officers or
directors of a fund's investment adviser, principal underwriter, or
certain of their affiliates not serve as independent directors of
the fund); Investment Company Institute, Resolution of the Board of
Governors of the Investment Company Institute (Oct. 3, 2003)
(resolving that ICI members adopt practices to disqualify persons
with certain family relationships from serving as independent
directors of funds) (http://www.ici.org/issues/dir/03_fund_gov_best_stmt.html
).
\25\ The annual self-assessment performed by the board under the
amended rules also may enable independent directors to identify
subject areas, such as valuation of portfolio securities, in which
the board needs future independent directors to have expertise. See
infra Section III.C.
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III. Discussion of New Rules
We are amending the ten Exemptive Rules under the Act \26\ to
require that any fund that relies upon any of those rules \27\ satisfy
the fund governance standards set forth in rule 0-1(a)(7): (i) at least
75 percent of the directors of the fund must be independent directors
or, if the fund board has only three directors, all but one of the
directors must be independent directors; (ii) the chairman of the board
must be an independent director; (iii) the board must perform a self-
assessment at least once annually; (iv) the independent directors must
meet separately at least once a quarter; and (v) the independent
directors must be affirmatively authorized to hire their own staff.\28\
We are also amending rule 31a-2 as proposed, to require that a fund
retain copies of written materials that the board considers when
approving the fund's advisory contract.\29\
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\26\ See supra note 9.
\27\ The fund governance conditions of the Exemptive Rules apply
to investment companies, including registered investment companies
and business development companies, if they rely on these rules.
\28\ Rule 0-1(a)(7) [17 CFR 270.0-1(a)(7)], which defines the
term ``fund governance standards,'' incorporates the following fund
governance requirements with which funds have had to comply since
2001 in order to rely upon any of the Exemptive Rules: (i) a fund's
board must have a majority of independent directors, (ii) the fund's
independent directors must select and nominate any other independent
directors, and (iii) any person acting as legal counsel to the
independent directors must be an ``independent legal counsel.'' See
2001 Adopting Release, supra note 2. The majority independence
condition also is being revised to a 75 percent independence
condition.
\29\ We are also adopting technical amendments to rule 10f-3 to
revise certain cross-references within the rule.
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A. Board Composition
As discussed above, when Congress passed the Investment Company
Act, it relied on independent directors to protect the interests of
fund investors. A principal purpose of the amendments is to strengthen
the independent directors' control of the fund board and its agenda, so
that the interests of investors are paramount. Although the Exemptive
Rules currently require a simple majority of the board to be
independent and the independent directors to separately approve the
transactions covered by those rules, we are concerned that many boards
continue to be dominated by their management companies. Accordingly,
the amendments provide that each fund relying on any Exemptive Rule
must have a board of directors whose independent directors constitute
at least 75 percent of the board or, if the fund has only three
directors, all but one of the directors must be independent.\30\ Most
commenters supported the 75 percent amendment.\31\ Some commenters
recommended that we adopt an even higher percentage.\32\ We
[[Page 46382]]
do not believe that we need to go that far--there are good arguments
for maintaining a management presence on the board. Other commenters
questioned whether a slightly lower super-majority requirement (e.g.,
two-thirds) would suffice.\33\ We believe the 75 percent requirement
adopted by Congress in section 15(f) of the Act will better assure that
the independent directors can carry out their fiduciary
responsibilities.\34\ This requirement was designed to help resolve
ongoing conflicts of interest, which can result from the sale of an
advisory firm.
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\30\ See rule 0-1(a)(7)(i).
\31\ We received approximately 98 comments on this proposed
amendment. Comments were submitted from investors, directors (both
interested and independent), funds, trade associations, and fund
service providers.
\32\ See, e.g., Letter from Tom Walker to Jonathan G. Katz,
Secretary, SEC (Mar. 9, 2004), File No. S7-03-04 (recommending that
fund boards be completely independent); Letter from John and Judy
Hesselberth to Jonathan G. Katz, Secretary, SEC (Feb. 24, 2004),
File No. S7-03-04 (recommending that the percentage be 100%).
\33\ See, e.g., Letter from Association for Investment
Management and Research to Jonathan G. Katz, Secretary, SEC (Mar.
19, 2004), File No. S7-03-04.
\34\ See, e.g., Letter from John E. Murray, Jr., Lead Director,
The Federated Funds, to Jonathan G. Katz, Secretary SEC (Mar. 11,
2004), File No. S7-03-04 (``Murray Letter''). A few commenters
recommended that the independence requirements established by the
Investment Company Act be tightened. Letter from Independent
Directors of the Vanguard Funds to Jonathan G. Katz, Secretary, SEC
(Mar. 10, 2004), File No. S7-03-04. See section 2(a)(19) (definition
of ``interested person'').
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Requiring that each fund that relies upon any Exemptive Rule have a
board of directors whose independent directors constitute at least 75
percent of the board, will help ensure that independent directors carry
out their fiduciary responsibilities. Management controls the day-to-
day activities of the fund and has significantly greater access to
information about the fund than do the independent directors. This
information gives the management directors a significant advantage over
the independent directors in setting the board's agenda and potentially
dominating board deliberations. The amendments seek to resolve this
imbalance. As one commenter noted, ``For fund boards to have
credibility as they fulfill this responsibility, the board must be
firmly under the control of those directors whose sole responsibility
is to look out for the interests of shareholders.'' \35\
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\35\ Consumer Federation Letter, supra note 4. See also Letter
from David Certner, Federal Affairs, AARP, to Jonathan G. Katz,
Secretary, SEC (Mar. 12, 2004), File No. S7-03-04 (``Certner
Letter'') (``By requiring that three-quarters of board members--
including the chairman--be independent, the proposed rule helps to
ensure that this oversight function will be controlled by
individuals whose sole obligation is to ensure that shareholders'
interests are protected'').
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A fund board whose independent directors constitute at least 75
percent of the fund board should strengthen the hand of the independent
directors when dealing with fund management,\36\ and may assure that
independent directors maintain control of the board \37\ and its
agenda.\38\
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\36\ As we noted when we proposed these amendments, section
15(f) of the Act, which provides a safe harbor for the sale of an
advisory business, requires that fund directors who are independent
of the adviser constitute at least 75 percent of the fund board for
three years following the assignment of the advisory contract, and
that no unfair burden be imposed on the fund. 15 U.S.C. 80a-15(f).
This increased independence of the board was designed to help
protect the fund from receiving unfair treatment in circumstances
involving potential conflicts of interest. See S. Rep. No. 75, 94th
Cong., 1st Sess. 140 (1975) (``These conditions are designed to
prevent any unfair burden from being imposed on the investment
company in connection with such a transaction.''). Because the
Exemptive Rules permit certain transactions that involve potential
harm to the fund as a result of conflicts of interest, see supra
notes 10-11 and accompanying text, we anticipate that a 75 percent
level of independence will similarly equip fund boards to monitor
and guard against such harms in connection with the activities of
the fund undertaken in reliance on those Rules.
\37\ As one commenter noted, a 75 percent level can be more
effective than a simple majority in ensuring control of the board by
independent directors if one or more independent directors are
absent from a board meeting. See Consumer Federation Letter, supra
note 4 (``[I]f one or more of the independent directors has a
mediocre attendance record, the majority [of independent directors]
may in reality function as a minority.'').
\38\ Control of the board and its agenda by fund management can
hinder the ability of the directors to oversee the fund's operations
under the Exemptive Rules. See, e.g., Repurchase Offers by Closed-
End Management Investment Companies, Investment Company Act Release
No. 19399 (Apr. 7, 1993) [58 FR 19330 (Apr. 14, 1993)] (noting the
need for active independent director involvement in the oversight of
rule 23c-3 because the determination of the amount of each
repurchase offer presents a potential conflict of interest between
the investment adviser and shareholders: the investment adviser may
be interested in making a small repurchase offer in order to retain
maximum assets under management).
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The final rule differs from the proposed rule in one respect. The
proposed rule would have required simply that any fund relying on an
Exemptive Rule have a board of directors with at least 75 percent
independent directors. Some commenters from funds with small boards
expressed concern about the costs of hiring new directors to meet this
requirement. A 75 percent standard would require a three-person board
with two independent directors to either replace its inside director
with an independent director, hire an additional independent director
to satisfy the new standard, or seek the resignation of the interested
director. We are sensitive to the costs of our rules and therefore have
modified the final rule to include an exception for boards with three
directors. The final rule provides that a board with three directors
satisfies the independence requirement if all but one of the directors
(i.e., two directors) are independent.\39\
---------------------------------------------------------------------------
\39\ See rule 0-1(a)(7)(i).
---------------------------------------------------------------------------
B. Independent Chairman of the Board
We are adopting an amendment to require that any fund that relies
on an Exemptive Rule have a chairman of its board who is an independent
director.\40\ We received approximately 152 comments on this amendment,
which was the most controversial among the fund governance standards we
proposed. The comments were divided between those supporting and those
opposing the amendment. Those supporting the amendment,\41\ including
investors and investor groups, stated that an independent chairman
would provide many benefits, including better protection of fund
shareholders.\42\
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\40\ See rule 0-1(a)(7)(iv).
\41\ See, e.g., Certner Letter, supra note 35. See also Letter
from James J. McMonagle to William H. Donaldson, Chairman, SEC (Jan.
14, 2004), File No. S7-03-04 (``McMonagle Letter''); Letter from
Patricia Rizzolo to Jonathan G. Katz, Secretary, SEC (Feb. 24,
2004), File No. S7-03-04.
\42\ See supra note 11.
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A fund board's primary responsibility is to protect the interest of
the fund and its shareholders, which may be adversely affected by the
substantial ongoing conflicts of interest of the fund management
company.\43\ The consequences of these conflicts are well demonstrated
by many of our ongoing enforcement actions involving late trading,
inappropriate market timing and misuse of nonpublic portfolio
information.\44\ We believe that a fund board is in a better position
to protect the interests of the fund, and to fulfill the board's
obligations under the Act and the Exemptive Rules,\45\ when its
chairman does not have the conflicts of interest inherent in the role
of an executive of the fund adviser.\46\
---------------------------------------------------------------------------
\43\ See 2001 Adopting Release, supra note 2. See also S. Rep.
No. 76-1775, at 6-7 (1940); S. Rep. No. 91-184, at 5-6 (1969);
Division of Investment Management, Protecting Investors: A Half
Century of Investment Company Regulation 255-263 (1992).
\44\ See supra note 4.
\45\ See supra note 9 (describing the responsibilities of fund
directors and independent directors to oversee fund activities
pursuant to the Exemptive Rules).
\46\ A number of our Exemptive Rules require the board to
address the fund's activities in circumstances involving these
conflicts of interest. See, e.g., rule 12b-1(b)(2) (requiring the
fund board to approve the plan for using fund assets to pay for the
distribution of fund shares); Bearing of Distribution Expenses by
Mutual Funds, Investment Company Act Release No. 11414 (Oct. 28,
1980) [45 FR 73898 (Nov. 7, 1980)] (noting the conflicts of interest
between the fund and its adviser when fund assets are used for
distribution of shares); rule 17a-8 (requiring directors to request
and evaluate information reasonably necessary to determine that the
merger of the fund with an affiliated fund is in the fund's best
interests, and to determine that the interests of fund shareholders
will not be diluted as a result of the merger); Investment Company
Mergers, Investment Company Act Release No. 25666 (July 18, 2002)
[67 FR 48511 (July 24, 2002)] (discussing some of the factors that
directors should consider in approving affiliated fund mergers);
rule 15a-4 (permitting temporary contract between fund and
investment adviser without shareholder approval); Temporary
Exemption for Certain Investment Advisers, Investment Company Act
Release No. 23325 (July 22, 1998) [63 FR 40231 (July 28, 1998)] at
text accompanying notes 24-25 (noting the responsibility of the
board under rule 15a-4 to determine that the scope and quality of
services under the temporary contract are at least equivalent to
those under the previous contract, and noting that the board is
empowered to terminate the temporary contract upon short notice, in
order to allow it to act quickly if advisory services decline in
quality).
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[[Page 46383]]
The board chairman 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.\47\ We believe that a
fund chairman is in the best position to fulfill these responsibilities
when his loyalty is not divided between the fund and its investment
adviser.
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\47\ See Letter from Anne J. Mills, Trustee, to Jonathan G.
Katz, Secretary, SEC (Feb. 2, 2004), File No. S7-03-04 (stating that
while appointing a lead independent director has improved
involvement of independent trustees, ``it is still difficult to
influence the Board meeting agenda to assure full discussion of the
more important items. Having an independent chair will significantly
change the dynamics of the board meetings.''); Letter from Ashok N.
Bakhru, Chairman of the Board and Independent Trustee, Goldman Sachs
Trust and Goldman Sachs Variable Insurance Trust, to Jonathan G.
Katz, Secretary, SEC (Mar. 9, 2004), File No. S7-03-04 (supporting
the amendment and adding that ``It has been our experience that the
chairman can provide an important and meaningful role in the
preparation of board agenda and in fostering the dialogue between
fund management and the independent directors on fund-related
matters.'').
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Those opposing the amendment, including some independent directors,
argued that it would deprive the independent directors of the ability
to choose for themselves the most qualified and capable candidate to
serve as chairman and thereby undermine the directors' ability to carry
out their responsibilities.\48\ To be clear, the amendments we are
adopting today do not prevent the independent directors from choosing
the most qualified and capable candidate. That candidate, however,
cannot serve two masters.
---------------------------------------------------------------------------
\48\ See Letter from Investment Company Institute to Jonathan G.
Katz, Secretary, SEC (March 10, 2004), File No. S7-03-04; Murray
Letter, supra note 34.
---------------------------------------------------------------------------
Some asserted that independent directors would not have sufficient
knowledge or be as well prepared to lead the board through its many
tasks, unless the board chairman is affiliated with the adviser and
therefore is able to obtain needed information from the advisory
firm.\49\ They similarly argued that the independent chairman might be
drawn into the day-to-day management of the fund. As noted above, we
believe a board chairman typically plays an important role in setting
the agenda of the board and determining what information is provided to
the board. An independent chairman will undoubtedly consult with
management in carrying out its functions, as well as in leading the
board through its various tasks. But the final decisions in setting the
agenda will be made by someone independent of management.\50\ Moreover,
the chairman is in a unique position to set the tone of meetings, and
to encourage open dialogue and healthy skepticism. We believe an
independent chairman is better equipped to serve this role. Finally,
representatives of management would still be responsible for the day-
to-day operations of the fund, would continue to be able to serve as
fund directors and would have access to information from the adviser.
We do not believe that this amendment will deprive the board of
management's knowledge and judgment.
---------------------------------------------------------------------------
\49\ See Letter from F. Pierce Linaweaver, Chairman of the
Committee of Independent Directors, T. Rowe Price Mutual Funds, to
Jonathan G. Katz, Secretary, SEC (Feb. 25, 2004), File No. S7-03-04.
\50\ See Letter from Chairman Michael G. Oxley, House Committee
on Financial Services, to William H. Donaldson, Chairman, SEC (May
20, 2004), File No. S7-03-04 (``I believe the Commission's
independent chairman proposal would eradicate the self-dealing by
interested, management-affiliated chairmen and its harmful effects
on mutual fund shareholders.'') (``Chairman Oxley Letter'').
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If the board is to provide effective oversight of the management
company, there may be times when it must be prepared to say ``no'' to
the manager's chief executive officer.\51\ We do not mean to suggest
that the relationship between the board and the management company need
be adversarial. Indeed, we believe that a crucial challenge to every
fund board involves establishing an appropriate balance between
cooperation with the management company and oversight of the management
company. Our primary concern, and the one that has led us to adopt this
amendment, is that too often the proper balance has not been achieved,
particularly where an executive of the adviser has exerted a dominant
influence over the board. While having an independent chairman should
not disadvantage a board that is properly balanced, it may
significantly benefit one that is not.
---------------------------------------------------------------------------
\51\ We received a particularly insightful comment letter from a
fund independent director who stated that his board's appointment of
an independent chairman was instrumental in causing the board to
switch fund advisers. See McMonagle Letter, supra note 41 (stating
that the mutual fund of which the author was an independent director
changed the advisory contract from one adviser to another, and
observing that ``[i]f the Chairman of the [mutual fund's board] had
not been independent, I am satisfied that we would not have moved
the advisory contract.'') (emphasis omitted). See also Letter from
David S. Ruder, Chairman, and Allan S. Mostoff, President and
Treasurer, Mutual Fund Directors Forum, to Jonathan G. Katz,
Secretary, SEC (May 14, 2004), File No. S7-03-04 (stating that the
Mutual Fund Directors Forum will recommend as a best practice that
fund boards be chaired by an independent director, because that
approach would enhance the power and authority of independent
directors and eliminate the chairman's conflicts of interest).
---------------------------------------------------------------------------
Some have argued that the Commission needs to demonstrate
conclusively that there is a link between having an independent
chairman and increased performance or decreased fund expenses.\52\ The
Commission considered its own and its staff's experience, the many
comments received, and other evidence, in addition to the limited and
conflicting empirical evidence. From this, we
[[Page 46384]]
believe that having independent chairmen can provide benefits and serve
other purposes apart from achieving high performance of the fund. In
this regard, corporate governance experts have pointed more generally
to the value that an independent chairman brings to a corporate board
of directors.\53\
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\52\ We are not aware of any conclusive research that
demonstrates that the hiring of an independent chairman will improve
fund performance or reduce expenses, or the reverse. Commenters did
not refer us to any pre-existing studies that spoke to this issue.
One commenter submitted a study that it commissioned in response to
the proposal, that sought to ascertain a correlation between
independent chairmen and the performance and expenses of funds. With
regard to performance, the study found a correlation between funds
with management chairmen and higher performance. The study noted,
however, that this correlation may be due to ``other important
differences [than independence of the chairmen] that may have
impacted performance results,'' such as the prevalence of
independent chairmen among bank-sponsored fund groups. With regard
to fund expenses, the study found, depending on the method of
calculation, lower (but not statistically significant) expenses
associated with independent chairmen funds, or higher expenses for
those types of funds. The study stated that the expense analysis
comparisons were less clear than with the performance results, and
``differ considerably depending on what expense measure is used.''
See Geoffrey H. Bobroff and Thomas H. Mack, Assessing the
Significance of Mutual Fund Board Independent Chairs, A Study for
Fidelity Investments (Mar. 10, 2004) (attached to Letter from Eric
D. Roiter, Senior Vice President and General Counsel, Fidelity
Management & Research Company to Jonathan G. Katz, Secretary, SEC
(Mar. 18, 2004), File No. S7-03-04)). On the other hand, some
commenters viewed the data differently and concluded that
``[i]ndependently-chaired funds did only slightly better in terms of
returns, but at lower cost * * *. Even accepted at face value,
Fidelity's data constitute muddy and unpersuasive evidence for
continuing to allow senior management company officials to sit in
the fund chairman's chair.'' Remarks by John C. Bogle, Founder and
Former CEO, The Vanguard Group, before the Institutional Investor
Magazine Mutual Fund Regulation and Compliance Conference (May 5,
2004), File No. S7-03-04. See also Letter from John A. Hill,
Chairman, The Putnam Funds, to William H. Donaldson, Chairman, SEC
(May 12, 2004), File No. S7-03-04.
\53\ See Ira M. Millstein and Paul W. MacAvoy, Proposals for
Reform of Corporate Governance, in The Recurrent Crisis in Corporate
Governance 95, 119 (2003) (``The first important initiative is for
the [corporate] board * * * to develop an identified independent
leadership, by separating the roles of chairman of the board and CEO
and appointing an independent director as chairman. Independent
leadership is critical to positioning the board as an objective body
distinct from management. * * * The board cannot function without
leadership separate from the management it is supposed to monitor.
On behalf of the shareholders, the board must be enabled to obtain
the information necessary to monitor * * * the performance of
management * * *.''). See also Consumer Federation Letter, supra
note 4 (``In light of the fact that the board's chief responsibility
is to police conflicts of interest and ensure that shareholders'
interests are protected, it is also symbolically important that the
chairman be independent. Putting a representative of the investment
adviser in this position creates the appearance, and inevitably in
some cases, the reality, that the fox is guarding the henhouse.'').
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We harbor no illusions that the designation of an independent
chairman will address all of the compliance and other problems
confronting funds.\54\ The rules we are adopting today are part of a
larger package of regulatory reforms designed both to prevent the
compliance failures of yesterday and to strengthen a fund board's
ability to deal with compliance challenges of the future. A key element
of that larger package is our rule requiring each fund to designate a
chief compliance officer who reports directly to the fund board.\55\
With the information about fund compliance matters now required by our
rule 38a-1, and the information about advisory contract renewal
required by section 15(c) of the Act, fund boards are better able to
fulfill their responsibilities.\56\
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\54\ One commenter, however, provided statistics indicating that
a large majority of mutual fund families implicated in recent
scandals have had management-affiliated chairmen at some point
during the alleged or admitted violations. Chairman Oxley Letter,
supra note 50.
\55\ See Compliance Programs, supra note 7.
\56\ Section 15 requires that fund directors, including a
majority of independent directors, approve the fund's advisory
contract each year. The directors must approve the advisory contract
initially, and annually thereafter if it continues in effect for
more than two years. Section 15(a) and (c) of the Act [15 U.S.C.
80a-15(a) and (c)]. It also requires that the directors first obtain
from the adviser the information reasonably necessary to evaluate
the contract so that directors would have adequate information upon
which to base their decision about the advisory contract generally
and the advisory fee in particular. Section 15(c) of the Act [15
U.S.C. 80a-15(c)].
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We carefully considered alternatives suggested to us by commenters,
including designation of a lead independent director and increased
reliance on board committees chaired by independent directors. A lead
independent director could provide useful leadership to the independent
directors when dealing with the board chairman,\57\ and independent
committee chairmen may provide important services to the fund. Neither
of these arrangements, however, would create a position that is likely
to be filled by a person with sufficient stature within the fund
complex to serve as an effective counterweight to a fund chairman who
may also be the chief executive officer of the management company.\58\
Further, as commenters pointed out, ``[a]ppointing a lead director does
nothing to ensure that independent directors control the agenda,
information requests, and terms of board debate.'' \59\ Commenters
recommended a variety of other alternatives, including having the audit
committee chair set the agenda. We believe that the board's agenda
should be under the control of an independent director.
---------------------------------------------------------------------------
\57\ See ICI Advisory Group Report, supra note 24, at 25
(recommending that independent directors designate one or more lead
independent directors).
\58\ See Letter from Fergus Reid III to William H. Donaldson,
Chairman, SEC (May 18, 2004), File No. S7-03-04 (``The Lead Director
concept is flawed--A lead director is immediately at a disadvantage
when dealing with a strong interested chairman. To assert him or
herself, the lead director must oppose or go around the wishes of an
interested chairman. This creates tension and ill will and is rarely
politically expedient''). The by-laws of some funds may state that
the board chairman is an officer of the fund. Under the amendments
we are adopting today, a fund in those circumstances that relies on
an Exemptive Rule would need to amend its by-laws, because an
officer of the fund is an interested person of the fund. See section
2(a)(19)(A)(i) of the Act [15 U.S.C. 80a-2(a)(19)(A)(i)] (definition
of ``interested person''). Funds whose by-laws do not contain such a
requirement also may wish to amend their by-laws to require that the
chairman be an independent director, as a good corporate practice,
to help ensure that a fund relying upon any Exemptive Rule satisfies
these fund governance standards. In either case, funds would have to
disclose the appointment of any new chairman and the changes to by-
laws in their filings with the Commission.
\59\ See Consumer Federation Letter, supra note 4.
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Our action today should not be construed as diminishing the value
that executives of the adviser, including the adviser's chief executive
officer, bring to the fund boardroom. We fully expect that these
executives will continue to serve on fund boards, although not in the
capacity of chairman, and thus will have every opportunity to engage
the board on issues important to the fund investors as well as the
management company.\60\ Similarly, to the extent that some executives
of the adviser leave fund boards in order to meet the supermajority
requirement, we expect that they will continue to participate, in
appropriate circumstances, in board and board committee deliberations.
---------------------------------------------------------------------------
\60\ Rule 0-1(a)(7)(iv) provides that a fund may rely on an
Exemptive Rule only if an independent director serves as chairman of
the board of directors of the fund, presides over meetings of the
board of directors and has substantially the same responsibilities
as would a typical chairman of a board of directors. In response to
the amendments we are adopting today, some funds might be tempted to
circumscribe the role of the independent chairman to preserve the
current role of an interested board chairman. We caution against
such action, which may result in the loss of multiple exemptions
from provisions of the Act and multiple violations of the Act. For
example, a fund could not designate an interested director to
preside over meetings or set meeting agendas, or name an interested
director as a ``co-chairman'' of the board. We would not, however,
consider temporary performance of a chairman's duties (e.g., due to
a chairman's illness or inability to attend) by an interested
director (e.g., by a vice chairman) as a failure to meet the
requirements of rule 0-1(a)(7)(iv).
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C. Annual Self-Assessment
We are also amending the Exemptive Rules to require fund directors
to evaluate, at least once annually, the performance of the fund board
and its committees.\61\ This evaluation must include a consideration of
the effectiveness of the committee structure of the fund board \62\ and
the number of funds on whose boards each director serves. Most
commenters supported this amendment, and we are adopting it as
proposed.
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\61\ See rule 0-1(a)(7)(v).
\62\ The requirement is designed to focus the board's attention
on the need to create, consolidate or revise the various board
committees, such as the audit, nominating or pricing committees, and
to facilitate a critical assessment of the effectiveness of current
board committees.
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This annual self-assessment requirement is intended to improve fund
performance by strengthening directors' understanding of their role and
fostering better communications and greater cohesiveness. Moreover, the
requirement should help fund boards to identify potential weaknesses
and deficiencies in the board's performance. The amendment does not
require that the board's self-assessment be in writing. Nevertheless,
we would expect that the minutes of the board would reflect the
substance of the matters discussed during the board's annual self-
assessment.\63\
---------------------------------------------------------------------------
\63\ See Proposing Release, supra note 2, at n.37.
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D. Separate Sessions
We are also amending the Exemptive Rules to require independent
directors to meet at least once quarterly in a separate session at
which no directors who are interested persons of the fund are
present.\64\ Commenters supported
[[Page 46385]]
this provision, which is designed to give independent directors the
opportunity for a frank and candid discussion among themselves
regarding the management of the fund, including its strengths and
weaknesses.\65\ The rule does not specify the matters that should be
discussed by the independent directors at the separate executive
sessions, although we expect that the independent directors would use
this forum to discuss, among other things, their views on the
performance of the fund adviser and other service providers.
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\64\ See rule 0-1(a)(7)(vi).
\65\ We anticipate that the frank and candid discussion among
the independent directors also would cover the fund's activities
pursuant to the Exemptive Rules. The independent directors, for
example, could discuss the use of fund assets to pay for the
distribution of fund shares under rule 12b-1 and the fund's 12b-1
plan adopted by the board. See supra note 46.
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E. Independent Director Staff
The final amendment to the Exemptive Rules we are adopting today
requires funds to explicitly authorize the independent directors to
hire employees and to retain advisers and experts necessary to carry
out their duties.\66\ Commenters supported this amendment, which is
designed to enable independent directors to hire employees and others
who will help them deal with matters beyond their expertise. We expect
that the amendment should help independent directors address complex
matters and provide them with an understanding of the practices of
other mutual funds.\67\ Fund shareholders should receive substantial
benefits because we expect that these requirements will help to ensure
that independent directors are better able to fulfill their role of
representing shareholder interests.\68\
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\66\ See rule 0-1(a)(7)(vii). The amendment does not require
independent directors to hire employees or retain advisers or
experts.
\67\ Some of the Exemptive Rules, for example, require that fund
directors oversee complex transactions. See, e.g., rule 10f-3
(permitting funds to purchase securities in a primary offering when
an affiliated broker-dealer is a member of the underwriting
syndicate if the fund's board, including a majority of its
independent directors, (i) approves procedures regulating purchases
of these securities and (ii) determines at least quarterly that the
purchases complied with the board-approved procedures). The rules
also require directors of funds relying on the rules to exercise
vigilance in protecting funds and their investors. See, e.g.,
Exemption for the Acquisition of Securities During the Existence of
an Underwriting or Selling Syndicate, Investment Company Act Release
No. 22775 (July 31, 1997) [62 FR 42401 (Aug. 7, 1997)], at n.52 and
accompanying text (the fund's board should be ``vigilant'' not only
in reviewing the fund's compliance with the procedures required by
rule 10f-3, but also ``in conducting any additional reviews that it
determines are needed to protect the interests of investors'').
Directors may need to hire staff to help conduct these reviews.
\68\ One of the most useful advisers independent directors
should consider engaging is their own counsel. Although we are not
requiring independent directors to have their own counsel, we agree
with the American Bar Association's view that ``[t]he complexities
of the Investment Company Act, the nature of the separate
responsibilities of independent directors and the inherent conflicts
of interest between a mutual fund and its managers effectively
require that independent directors seek the advice of counsel in
understanding and discharging their special responsibilities.''
American Bar Association, Report of the Task Force on Independent
Director Counsel, Subcommittee of Investment Companies and
Investment Advisers, Committee on Federal Regulation of Securities,
Section of Business Law: Counsel to the Independent Directors of
Registered Investment Companies at 3 (Sept. 8, 2000). See generally
James D. Cox, Symposium: Lessons from Enron, How Did Corporate and
Securities Law Fail? Managing and Monitoring Conflicts of Interests:
Empowering the Outside Directors with Independent Counsel, 48 Vill.
L. Rev. 1077 (2003). If independent directors do hire their own
counsel, and their fund relies on any of the Exemptive Rules, such
counsel must be an ``independent counsel.'' Rule 0-1(a)(7)(iii).
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F. Recordkeeping for Approval of Advisory Contracts
Finally, we are amending rule 31a-2, the fund recordkeeping rule,
to require that funds retain copies of the written materials that
directors consider in approving an advisory contract under section 15
of the Investment Company Act.\69\ Commenters supported this amendment,
and we are adopting it as proposed.\70\ The amendment requires funds to
retain the materials for at least six years, the first two years in an
easily accessible place.
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\69\ See rule 31a-2(a)(6). See also supra note and accompanying
text.
\70\ We did not receive specific comment on the detailed
questions on which we sought comment pursuant to section 31(a)(2) of
the Act [15 U.S.C. 80a-30(a)(2)], i.e., whether there are feasible
alternatives to the proposed amendment that would minimize the
recordkeeping burdens, the necessity of these records in
facilitating the examinations carried out by our staff, the costs of
maintaining the required records, and any effects that the proposed
recordkeeping requirements would have on firms' internal compliance
policies and procedures. We have nevertheless considered those
issues in the course of adopting this recordkeeping rule amendment.
We do not believe that there are any feasible alternatives to the
amendment that would minimize recordkeeping burdens, and, as
discussed above, the records are necessary to facilitate the
examinations carried out by our staff. Finally, we are not aware of
any adverse effects that the recordkeeping requirement will have on
the nature of firms' internal compliance policies and procedures. In
fact, we anticipate that the recordkeeping requirement will
facilitate fund internal compliance programs because the fund's
compliance staff will be able to monitor the information on which
directors rely in approving the fund's advisory contract.
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The recordkeeping amendment is designed to improve the
documentation of a fund board's basis for approving an advisory
contract, which would assist our examination staff in determining
whether fund directors are fulfilling their fiduciary duties when
approving advisory contracts. The amendment underscores the importance
of the information requests that precede the directors' consideration
of the advisory contract. Further, it may encourage independent
directors to request more information, and this information may enable
them to obtain more favorable terms in advisory contracts.
IV. Effective Date; Compliance Date
The amendments to the Exemptive Rules will become effective on
September 7, 2004.
After January 15, 2006: (i) persons may rely upon any of the
Exemptive Rules (rules 10f-3, 12b-1, 15a-4(b)(2), 17a-7, 17a-8, 17d-
1(d)(7), 17e-1, 17g-1(j), 18f-3, and 23c-3) only if they comply with
all of the ``fund governance standards'' as defined in rule 0-1(a)(7);
\71\ and (ii) funds must begin to comply with the recordkeeping
requirements of amended rule 31a-2.
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\71\ After the effective date but before the compliance date of
the amendments, a person that relies on an Exemptive Rule must
continue to meet the fund governance requirements of the Exemptive
Rules we adopted in 2001 concerning a majority of independent
directors, independent director self-selection and self-nomination,
and independent legal counsel. See Proposing Release, supra note 2.
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V. Paperwork Reduction Act
As discussed in the Proposing Release, the amendment to rule 31a-2
contains a ``collection of information'' requirement within the meaning
of the Paperwork Reduction Act of 1995 \72\ because the amendment to
rule 31a-2 will require funds to retain copies of the written materials
that boards consider in approving advisory contracts under section
15(c) of the Investment Company Act. Funds have to retain these
materials for at least six years, the first two years in an easily
accessible place for our examiners. This collection of information is
necessary for our staff to use in its examination and oversight
program. Responses provided in the context of the Commission's
examination and oversight program are generally kept confidential. The
collection of information requirement is mandatory and is in the form
of an amendment to a currently approved collection of information
requirement, the title of which is ``Rule 31a-2, `Records to be
preserved by registered investment companies, certain majority-owned
subsidiaries thereof, and other persons having transactions with
registered investment companies.' ;'' An agency may not conduct or
sponsor, and a person is not required to respond to, a collection of
information unless it displays a currently valid control number. The
approved collection of information associated with rule 31a-2 to be
revised by the amendments
[[Page 46386]]
displays control number 3235-0179. The Commission submitted the
collection to the Office of Management and Budget (``OMB'') for review
in accordance with 44 U.S.C. 3507(d) and 5 CFR 1320.11. OMB has
approved the collection of information under control number 3235-0179
(expiring on July 31, 2007).
---------------------------------------------------------------------------
\72\ 44 U.S.C. 3501 to 3520.
---------------------------------------------------------------------------
The amendment to the collection of information requirement for rule
31a-2 is necessary for our compliance examiners to determine whether
fund boards have met the requirements of section 15 of the Investment
Company Act when approving investment advisory contracts. Our
compliance examiners will review these materials to gauge a fund
board's fulfillment of the requirements of section 15 of the Act.
As discussed above, we are adopting the amendment to rule 31a-2 and
this collection of information requirement as proposed. In the
Proposing Release, our staff estimated that each fund will spend a
total of 0.5 hours annually and a total of $9.46 for clerical time to
comply with this amendment.\73\ In the Proposing Release, we solicited
comments on the accuracy of these estimates. None of the comments
received specifically addressed our estimates of the costs associated
with the collection of information requirement.\74\ Our staff continues
to estimate that each fund will spend a total of 0.5 hours annually and
a total of $9.46 for clerical time to comply with this amendment.
Because of the increase in the number of registered funds to 5,132
funds, however, our staff estimates that the total hour burden of the
collection of information requirement for all funds is 2,566 hours and
a total of $48,548.72 annually to comply with this amendment.
---------------------------------------------------------------------------
\73\ In the Proposing Release, we estimated that 5,124 funds
would incur costs under this requirement. To calculate these costs,
our staff used $18.92 per hour as the average cost of clerical time.
We now estimate that there are 5,132 registered funds that may incur
costs under this amendment.
\74\ See Letter from James H. Bodurtha, Chair, Directors'
Committee, Investment Company Institute, to Jonathan G. Katz,
Secretary, SEC (Mar. 10, 2004), File No. S7-03-04 (stating that ``We
believe that the retention costs should be minimal and should not be
a consideration in the implementation of this proposal. Requiring
retention, in our opinion, will not change practices in terms of the
volume of information requested by directors in connection with
their review of the advisory contract.'') (``ICI Letter'').
---------------------------------------------------------------------------
VI. Cost-Benefit Analysis
We are sensitive to the costs and benefits imposed by our rules. As
discussed in section III above, these amendments require that funds
relying on any of the Exemptive Rules adopt certain governance
practices that are designed to enhance the independence and
effectiveness of fund boards. We also are adopting amendments to
require that funds maintain materials considered by a fund board when
approving an advisory contract. In the Proposing Release, we identified
probable costs and benefits of each of these proposed amendments that
we are adopting today, and we requested public comment on our analysis
of the costs and benefits of each of these amendments.
We expect that funds and fund shareholders are likely to benefit
from the amendments because they are designed to strengthen the role of
independent directors so that fund boards can more effectively manage
conflicts of interest, monitor service providers, and protect the
interests of fund shareholders. Boards that satisfy these conditions
should be more effective at exerting an independent influence over fund
management and other fund service providers because the fund
independent directors are more likely to be primarily loyal to the fund
shareholders rather than the fund adviser.
A. Benefits
The amendments seek to promote strong fund boards that effectively
perform their oversight role. By increasing the independence of fund
boards, the amendments are designed to improve the quality of the
oversight of the process for the benefit of fund investors. Vigilant
and informed oversight by a strong, effective and independent fund
board may help to prevent problems such as late trading and market
timing. These benefits may increase investor confidence in fund
management. While these benefits are not easily quantifiable in terms
of dollars, we believe they are real, and that the amendments will
strengthen the hand of independent directors to the advantage of
shareholders.\75\ A fund board whose independent directors constitute
at least 75 percent of the fund board should strengthen the hand of the
independent directors when dealing with fund management, and may assure
that independent directors maintain control of the board and its
agenda.\76\
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\75\ For a more complete discussion of the benefits to
shareholders and boards in overseeing a fund's activities under the
Exemptive Rules, see supra Section III.
\76\ The majority of commenters generally agreed that increasing
the independence of fund boards was beneficial to fund shareholders.
Some commenters recommended that the percentage of independent
directors be greater than 75 percent or that the conditions for
being an independent director be stricter.
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We expect that requiring fund boards to be chaired by an
independent director will provide similar benefits to increasing the
percentage of independent directors. Because the chairman of a fund
board can have a substantial influence on the fund board agenda and on
the fund boardroom's culture, we expect that this requirement will
advance meaningful dialogue between the fund adviser and independent
directors and will support the role of the independent directors in
overseeing the fund adviser. Further, we expect that the opportunity
for frank and candid discussions among independent directors that will
result from the rule amendments will increase the effectiveness of the
independent directors.\77\
---------------------------------------------------------------------------
\77\ Commenters were divided as to the relative benefits of this
requirement. See supra text following note 40.
---------------------------------------------------------------------------
The amendment to require an annual self-assessment of the
effectiveness of the board and its committees is intended to improve
fund performance by strengthening directors' understanding of their
role and fostering better communications and greater cohesiveness.
Moreover, the requirement for fund boards to perform an annual self-
assessment should help fund boards to identify potential weaknesses and
deficiencies. All but one of the comments received expressed support
for a requirement that boards perform a self-assessment.
We expect that the requirement that independent directors must meet
at least once quarterly in separate sessions, without the presence of
directors who are interested persons, likewise will improve fund
performance by strengthening the role of independent directors and
fostering better communications and greater cohesiveness among the
independent directors. Commenters were supportive of this proposal.
We expect that the amendment to require funds to explicitly
authorize independent directors to hire employees and to retain
advisers and experts will help independent directors address complex
matters and provide them with an understanding of the practices of
other mutual funds. Fund shareholders should receive substantial
benefits because we expect that these requirements will help to ensure
that independent directors are better able to fulfill their role of
representing shareholder interests. Most commenters expressed support
for this amendment. These commenters agreed that fund boards already
have the authority to hire
[[Page 46387]]
employees, but that this is a useful amendment.
Finally, the recordkeeping amendment is designed to improve the
documentation of a fund board's basis for approving an advisory
contract, which will assist our examination staff in determining
whether fund directors are fulfilling their fiduciary duties when
approving advisory contracts. The amendment to rule 31a-2 underscores
the importance of the information requests that precede the directors'
consideration of the advisory contract. Further, it may encourage
independent directors to request more information, and this information
may enable them to obtain more favorable terms in advisory contracts.
Comments generally were supportive of this amendment.
B. Costs
The amendments will impose additional costs on funds that rely on
an Exemptive Rule by requiring them to satisfy the fund governance
standards in rule 0-1(a)(7). The amendments will require that
independent directors constitute at least 75 percent of the fund board
or, if the fund board has only three directors, will require that all
but one director be independent.\78\ Therefore, a fund that does not
already meet this standard may: (i) Decrease the size of its board and
allow some interested directors to resign; (ii) maintain the current
size of its board and replace some interested directors with
independent directors; or (iii) increase the size of its board and
elect new independent directors. If a fund holds a shareholder
election, it will incur costs to prepare proxy statements and hold the
shareholder meeting. A fund also will incur costs of finding qualified
candidates and compensating those new independent directors.\79\ As
noted in the Proposing Release, our staff has no reliable basis for
determining how funds would choose to satisfy this requirement and
therefore it is difficult to determine the costs associated with
electing independent directors.\80\ As discussed in section III above,
under the proposed amendments, boards that have three directors, unlike
fund boards that have four or more directors, would have to be composed
of all independent directors in order to meet the 75 percent
requirement or, alternatively, would incur costs to increase their
board size to four directors. In response to concerns about the effect
of the requirement on boards with only three directors, the exception
to the 75 percent requirement we are adopting permits boards with three
directors to have all but one director be independent.
---------------------------------------------------------------------------
\78\ As indicated in the Proposing Release, our staff estimated
that nearly sixty percent of all funds currently meet this
requirement. See Proposing Release, supra note 2 .
\79\ Under some circumstances a vacancy on the board may be
filled by the board of directors. See section 16(a) of the
Investment Company Act [15 U.S.C. 80a-16(a)].
\80\ With respect to the requirements related to independent
selection and nomination of other independent directors and
independent legal counsel, this amendment incorporates the current
requirements of the Exemptive Rules, and therefore these amendments
do not impose new costs.
---------------------------------------------------------------------------
The amendments also require: (i) An independent director to be
chairman of the board; (ii) directors to perform an evaluation of the
board and its committees, at least once annually; (iii) independent
directors to meet in an executive session at which no director who is
an interested person of the fund is present, at least once quarterly;
and (iv) independent directors to be given specific authority to hire
employees and retain experts. As discussed in the Proposing Release,
our staff is not aware of any out-of-pocket costs that would result
from the first three items because these requirements could be
satisfied at a regularly scheduled board meeting.\81\ A few comments
expressed concern about costs of requiring separate executive sessions
at least once quarterly. However, as discussed in the Proposing
Release, we expect that most funds would choose to satisfy this
requirement by having directors meet at a breakout session of regularly
scheduled board meetings, which would impose no additional
transportation and little or no accommodation costs for the directors.
Therefore, we expect that the costs of complying with this requirement
would be minimal. With regard to the fourth item, our staff is not
aware of any costs associated with hiring employees or retaining
experts because boards typically have this authority under state law,
and the rule would not require them to hire employees or retain
experts.
---------------------------------------------------------------------------
\81\ There may, however, be indirect costs associated with these
provisions. An independent chairman, for example, may choose to hire
staff for assistance in carrying out his or her responsibilities as
chairman. We have no reliable basis for estimating those costs.
---------------------------------------------------------------------------
Our staff expects that the amendment to require funds to retain
copies of materials considered by the board in approving advisory
contracts would result in some increased recordkeeping costs. Our staff
anticipates that the increased costs will be limited, however, because
many if not most funds already maintain the documents that the proposed
amendment would require them to keep. Even for firms that do not
already maintain such records, our staff anticipates that the costs of
the amendment will be limited.\82\ This recordkeeping proposal merely
requires the retention of documents already prepared. Further, as with
other records, funds would be able to maintain the required records
electronically. For purposes of the Paperwork Reduction Act, our staff
estimated that each fund will spend a total of 0.5 hours of clerical
time annually, at a total of $9.46, to comply with this proposal. We
requested comment on the number of funds that already retain these
materials, and on the costs of retaining such materials. We did not
receive any comments specifically addressing this issue.\83\
---------------------------------------------------------------------------
\82\ For purposes of the Paperwork Reduction Act, our staff
estimates that each fund would spend approximately 0.5 hours
annually maintaining records of documents reviewed by fund boards
when approving advisory contracts. See Proposing Release, supra note
2, at Section IV.
\83\ See ICI Letter, supra note 74.
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VII. Final Regulatory Flexibility Analysis
This Final Regulatory Flexibility Analysis (``FRFA'') has been
prepared in accordance with 5 U.S.C. 604 relating to the amendments to
the Exemptive Rules and the Commission's rules on investment company
governance. An Initial Regulatory Flexibility Analysis (``IRFA'') was
prepared in accordance with 5 U.S.C. 603 and was published in the
Proposing Release.\84\
---------------------------------------------------------------------------
\84\ See Proposing Release, supra note 2, at Section VI.
---------------------------------------------------------------------------
A. Reasons for and Objectives of the Amendments
As described in Section I of this Release and in the Proposing
Release, the Investment Company Act relies heavily on fund boards of
directors to manage conflicts of interest that the fund adviser
inevitably has with the fund. The reasons for these amendments are that
the breakdown in fund management and compliance controls evidenced by
our enforcement cases raises troubling questions about the ability of
many fund boards, as presently constituted, to effectively oversee the
management of funds. The objectives of the amendments, which apply to
funds relying on any of the Exemptive Rules, are to enhance the
independence and effectiveness of fund boards and to improve their
ability to protect the interests of the funds and fund shareholders
they serve and to effectively oversee management of the fund.
[[Page 46388]]
B. Significant Issues Raised by Public Comment
In the IRFA, we requested comment on any aspect of the IRFA and
specifically requested comment on the number of small entities that
would be affected by the proposed amendments, the likely impact of the
proposal on small entities, and the nature of any impact, and empirical
data supporting the extent of the impact. We received a few comments on
the impact on small entities.\85\ Four commenters expressed concern
about the costs associated with hiring new directors for funds with
small boards to satisfy the requirement that 75 percent of the board be
independent. These commenters also stated that the costs associated
with the amendments would be great for small entities because of the
costs of retaining independent legal counsel, the cost of paying for
more directors, the costs of holding separate meetings for independent
directors, the costs of hiring staff for independent directors and the
costs of having an independent director serve as chairman.\86\
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\85\ These commenters defined small entities as entities with
assets ranging from assets under $218 million to assets under $100
million, as opposed to assets under $50 million.
\86\ These amendments that we proposed and are adopting,
however, do not require independent directors to retain independent
legal counsel or to hire staff for independent directors, nor do
these amendments require funds to increase the size of their boards.
---------------------------------------------------------------------------
C. Small Entities Subject to the Amendments
A small business or small organization (collectively, ``small
entity'') for purposes of the Regulatory Flexibility Act is a fund
that, together with other funds in the same group of related investment
companies, has net assets of $50 million or less as of the end of its
most recent fiscal year.\87\ Of approximately 5,132 registered
investment companies, approximately 233 are small entities.\88\ As
discussed above, the amendments would require funds relying on an
Exemptive Rule to comply with rule 0-1(a)(7) and all funds to retain
records under rule 31a-2. Whether these amendments to the Exemptive
Rules would affect small entities would depend on whether the small
entities rely on an Exemptive Rule.\89\ Under rule 31a-2, all small
entities would be required to maintain records of materials considered
by a fund board when approving an advisory contract.
---------------------------------------------------------------------------
\87\ 17 CFR 270.0-10.
\88\ Some or all of these entities may contain multiple series
or portfolios. If a registered investment company is a small entity,
the portfolios or series it contains are also small entities.
\89\ We now estimate that there are 5,132 registered funds, of
which 233 are small entities. As discussed in the Proposing Release,
our staff estimates that approximately 90 percent of all registered
investment companies, or 4,619 funds, rely on at least one Exemptive
Rule. If 90 percent of all small entities rely on at least one
Exemptive Rule, then approximately 210 funds that are small entities
would rely on at least one Exemptive Rule and would therefore be
affected by the amendments to the Exemptive Rules. See Proposing
Release, supra note 2.
---------------------------------------------------------------------------
D. Projected Reporting, Recordkeeping, and Other Compliance
Requirements
The amendments do not introduce any new mandatory reporting
requirements. The amendments contain new mandatory recordkeeping
requirements. Any fund, regardless of size, is required to maintain
records of written materials that directors consider to approve an
advisory contract. The amendments also introduce new compliance
requirements for any fund that relies on an Exemptive Rule. Any fund
that relies on an Exemptive Rule is required to satisfy the fund
governance standards in rule 0-1(a)(7), including having: (i) A board
of directors whose independent directors constitute at least 75 percent
of the board; \90\ (ii) an independent director be chairman of the
board; (iii) directors perform an evaluation of the board and its
committees, at least once annually; (iv) independent directors meet in
an executive session at which no director who is an interested person
of the fund is present, at least once quarterly; and (v) independent
directors be given specific authority to hire employees and other
advisers.
---------------------------------------------------------------------------
\90\ If the board consists of three directors, however, the
board need only include two independent directors.
---------------------------------------------------------------------------
E. Agency Action to Minimize the Effect on Small Entities
We are concerned about the impact of these amendments on small
entities. In response to comments about the impact of the proposed 75
percent independence requirement on small fund boards, we are adopting
an alternative for fund boards with only three directors.\91\ Unlike
fund boards composed of four or more directors, fund boards with only
three directors would have to be composed of all independent directors
in order to meet the 75 percent requirement or, alternatively, would
have increase their board size to four directors. We are adopting an
alternative to the 75 percent requirement for boards composed of three
directors that would permit all but one director to be independent.
With respect to the establishment of other special alternatives for
small entities, we do not presently think this is feasible or necessary
because these amendments are designed to strengthen the role of
independent directors so that fund boards can more effectively manage
conflicts of interest, monitor service providers, and protect the
interests of fund shareholders. The need to strengthen the role of
independent directors arises in part from problems uncovered in
enforcement actions and settlements. Excepting small entities from the
amendments could disadvantage fund shareholders of small entities and
compromise the effectiveness of the amendments. Because we believe that
small entities are as vulnerable to the problems uncovered in recent
enforcement actions and settlements as large entities, shareholders of
small entities are equally in need of more independent fund boards.
Thus, specific measures must be undertaken by all funds, regardless of
size, to increase the independence of boards to provide better
oversight of service providers and compliance matters, to better manage
conflicts of interest and to better protect fund shareholders.
---------------------------------------------------------------------------
\91\ We estimate that 30 funds that are small entities have
boards with only three directors.
---------------------------------------------------------------------------
VIII. Consideration of Promotion of Efficiency, Competition and Capital
Formation
Section 2(c) of the Investment Company Act requires the Commission,
when engaging in rulemaking that requires it to consider or determine
whether an action is necessary or appropriate in the public interest,
to consider whether the action will promote efficiency, competition,
and capital formation. The amendments requiring that funds adopt
certain governance practices if they rely on any of the Exemptive Rules
are designed to enhance the independence and effectiveness of fund
boards. The amendment to require that funds maintain materials
considered by a fund board when approving an advisory contract is
designed to improve the documentation of a fund board's basis for
approving an advisory contract, which would assist our examinations
staff in determining whether fund directors are fulfilling their
fiduciary duties when approving advisory contracts. We do not expect
these amendments to have a significant effect on efficiency,
competition and capital formation with regard to funds because the
costs associated with the amendments are minimal and many funds have
already adopted the required practices. To the extent that these
amendments do affect competition or capital formation, we believe that
the
[[Page 46389]]
effect will be positive because the amendments are likely to reduce the
risk of securities law violations such as late trading in mutual funds
and market timing violations, and thus increase investor confidence in
mutual funds. In the Proposing Release, we solicited comments on our
analysis of the impact of these amendments on efficiency, competition
and capital formation. We did not receive any comments on our analysis.
Statutory Authority
We are amending rule 0-1(a) and the Exemptive Rules pursuant to the
authority set forth in sections 6(c), 10(f), 12(b), 17(d), 17(g),
23(c), and 38(a) of the Investment Company Act [15 U.S.C. 80a-6(c),
80a-10(f), 80a-12(b), 80a-17(d), 80a-17(g), 80a-23(c), and 80a-37(a)].
We are amending rule 31a-2 under the Investment Company Act pursuant to
the authority set forth in sections 12(b) and 31(a) [80a-12(b) and 80a-
30(a)].
Text of Rules
List of Subjects in 17 CFR Part 270
Investment companies, Reporting and recordkeeping requirements,
Securities.
0
For the reasons set out in the preamble, the Commission is amending
Title 17, Chapter II of the Code of Federal Regulations as follows.
PART 270--RULES AND REGULATIONS, INVESTMENT COMPANY ACT OF 1940
0
1. The authority citation for Part 270 is amended by adding the
following citation in numerical order to read as follows:
Authority: 15 U.S.C. 80a-1 et seq., 80a-34(d), 80a-37, and 80a-
39, unless otherwise noted.
* * * * *
Section 270.0-1(a)(7) is also issued under 15 U.S.C. 80a-10(e);
* * * * *
0
2. Section 270.0-1 is amended by adding paragraph (a)(7) to read as
follows:
Sec. 270.0-1 Definition of terms used in this part.
(a) * * *
(7) Fund governance standards. The board of directors of an
investment company (``fund'') satisfies the fund governance standards
if:
(i) At least seventy-five percent of the directors of the fund are
not interested persons of the fund (``disinterested directors'') or, if
the fund has three directors, all but one are disinterested directors;
(ii) The disinterested directors of the fund select and nominate
any other disinterested director of the fund;
(iii) Any person who acts as legal counsel for the disinterested
directors of the fund is an independent legal counsel as defined in
paragraph (a)(6) of this section;
(iv) A disinterested director serves as chairman of the board of
directors of the fund, presides over meetings of the board of directors
and has substantially the same responsibilities as would a chairman of
a board of directors;
(v) The board of directors evaluates at least once annually the
performance of the board of directors and the committees of the board
of directors, which evaluation must include a consideration of the
effectiveness of the committee structure of the fund board and the
number of funds on whose boards each director serves;
(vi) The disinterested directors meet at least once quarterly in a
session at which no directors who are interested persons of the fund
are present; and
(vii) The disinterested directors have been authorized to hire
employees and to retain advisers and experts necessary to carry out
their duties.
0
3. Section 270.10f-3 is amended by:
0
a. Revising the reference to ``paragraphs (b)(1)(iv) and (b)(2)(i)'' to
read ``paragraphs (c)(1)(v) and (c)(2)(i)'' in paragraph (c)(3);
0
b. Revising the reference to ``paragraph (b)(10)(iii)'' to read
``paragraph (c)(10)(iii)'' in paragraph (c)(9);
0
c. Revising the reference to ``paragraphs (b)(10)(i) and (b)(10)(ii)''
to read ``paragraphs (c)(10)(i) and (c)(10)(ii)'' in paragraph
(c)(12)(i);
0
d. Revising the reference to ``paragraph (b)(10)(iii)'' to read
``paragraph (c)(10)(iii)'' in paragraph (c)(12)(ii); and
0
e. Revising paragraph (c)(11).
The revision reads as follows:
Sec. 270.10f-3 Exemption for the acquisition of securities during the
existence of an underwriting or selling syndicate.
* * * * *
(c) * * *
(11) Board composition. The board of directors of the investment
company satisfies the fund governance standards defined in Sec. 270.0-
1(a)(7).
* * * * *
0
4. Section 270.12b-1 is amended by revising paragraph (c) to read as
follows:
Sec. 270.12b-1 Distribution of shares by registered open-end
management investment company.
* * * * *
(c) A registered open-end management investment company may rely on
the provisions of paragraph (b) of this section only if its board of
directors satisfies the fund governance standards as defined in Sec.
270.0-1(a)(7);
* * * * *
0
5. Section 270.15a-4 is amended by revising paragraph (b)(2)(vii) to
read as follows:
Sec. 270.15a-4 Temporary exemption for certain investment advisers.
* * * * *
(b) * * *
(2) * * *
(vii) The board of directors of the investment company satisfies
the fund governance standards defined in Sec. 270.0-1(a)(7).
0
6. Section 270.17a-7 is amended by revising paragraph (f) to read as
follows:
Sec. 270.17a-7 Exemption of certain purchase or sale transactions
between an investment company and certain affiliated persons thereof.
* * * * *
(f) The board of directors of the investment company satisfies the
fund governance standards defined in Sec. 270.0-1(a)(7); and
* * * * *
0
7. Section 270.17a-8 is amended by revising paragraph (a)(4) to read as
follows:
Sec. 270.17a-8 Mergers of affiliated companies.
* * * * *
(a) * * *
(4) Board composition. The board of directors of the Merging
Company satisfies the fund governance standards defined in Sec. 270.0-
1(a)(7).
* * * * *
0
8. Section 270.17d-1 is amended by revising paragraph (d)(7)(v) to read
as follows:
Sec. 270.17d-1 Applications regarding joint enterprises or
arrangements and certain profit-sharing plans.
* * * * *
(d) * * *
(7) * * *
(v) The board of directors of the investment company satisfies the
fund governance standards defined in Sec. 270.0-1(a)(7).
* * * * *
0
9. Section 270.17e-1 is amended by revising paragraph (c) to read as
follows:
Sec. 270.17e-1 Brokerage transactions on a securities exchange.
* * * * *
(c) The board of directors of the investment company satisfies the
fund governance standards defined in Sec. 270.0-1(a)(7); and
* * * * *
[[Page 46390]]
0
10. Section 270.17g-1 is amended by revising paragraph (j)(3) to read
as follows:
Sec. 270.17g-1 Bonding of officers and employees of registered
management investment companies.
* * * * *
(j) * * *
(3) The board of directors of the investment company satisfies the
fund governance standards defined in Sec. 270.0-1(a)(7).
* * * * *
0
11. Section 270.18f-3 is amended by revising paragraph (e) to read as
follows:
Sec. 270.18f-3 Multiple class companies.
* * * * *
(e) The board of directors of the investment company satisfies the
fund governance standards defined in Sec. 270.0-1(a)(7).
* * * * *
0
12. Section 270.23c-3 is amended by revising paragraph (b)(8) to read
as follows:
Sec. 270.23c-3 Repurchase offers by closed-end companies.
* * * * *
(b) * * *
(8) The board of directors of the investment company satisfies the
fund governance standards defined in Sec. 270.0-1(a)(7).
* * * * *
0
13. Section 270.31a-2 is amended by:
0
a. Removing the word ``and'' at the end of paragraph (a)(4);
0
b. Removing the period at the end of paragraph (a)(5) and adding in its
place ``; and''; and
0
c. Adding paragraph (a)(6) to read as follows:
Sec. 270.31a-2 Records to be preserved by registered investment
companies, certain majority-owned subsidiaries thereof, and other
persons having transactions with registered investment companies.
(a) * * *
(6) Preserve for a period not less than six years, the first two
years in an easily accessible place, any documents or other written
information considered by the directors of the investment company
pursuant to section 15(c) of the Act (15 U.S.C. 80a-15(c)) in approving
the terms or renewal of a contract or agreement between the company and
an investment adviser.
* * * * *
Dated: July 27, 2004.
By the Commission.
Margaret H. McFarland,
Deputy Secretary.
Dissent of Commissioners Cynthia A. Glassman and Paul S. Atkins
Investment Company Governance, Release No. IC-26520
We write jointly to dissent from the Commission's adoption of
amendments to rules under the Investment Company Act of 1940
(``Investment Company Act'' or ``Act'') that generally require a
fund's board of directors: (1) To be composed of directors, at least
75 percent of whom are independent, and (2) to be led by an
independent director as its chairperson.\1\ We support the
rulemaking's commendable objective of strengthening investor
protection for fund shareholders. However, we fear that the path
chosen to achieve this objective may lead in the opposite
direction--at a substantial cost to fund shareholders. Because the
fund industry is a $7.6 trillion industry, it is easy to ignore or
lose sight of the fact that the costs of regulatory requirements are
ultimately paid by fund shareholders, for whom small differences in
fees are of great importance.\2\
---------------------------------------------------------------------------
\1\ The change is effected by making these governance
requirements conditions of ten commonly used exemptive rules.
Because these rules are used by virtually all funds, these
requirements are effectively universally applicable.
\2\ See, e.g., Securities and Exchange Commission, Invest
Wisely: An Introduction to Mutual Funds (available at: http://www.sec.gov/investor/pubs/inwsmf.htm
key) (``Even small
differences in fees can translate into large differences in returns
over time. For example, if you invested $10,000 in a fund that
produced a 10% annual return before expenses and had annual
operating expenses of 1.5%, then after 20 years you would have
roughly $49,725. But if the fund had expenses of only 0.5%, then you
would end up with $60,858--an 18% difference.'').
---------------------------------------------------------------------------
As the release indicates, although the benefits of the
amendments are difficult to quantify, a majority of the Commission
``believe[s] they are real.'' \3\ The majority postulates that the
new independence requirements will ``strengthen the hand of the
independent directors when dealing with fund management, and may
assure that independent directors maintain control of the board and
its agenda.'' \4\ However, despite the existence of empirical data
that could have been analyzed to evaluate potential benefits, the
proponents provided no such analysis. Moreover, the majority
speculates sanguinely that the benefits of these amendments will
come at ``minimal'' cost to funds.\5\ Positing that empirical
evidence is unnecessary, the majority dismisses pleas for more
deliberate action.\6\ A particular standard of independence is not,
in and of itself, a legitimate regulatory objective. Therefore,
before we mandate that all funds meet any particular independence
standard, it must be objectively linked (by more than anecdotal
evidence and ``gut impression'') to real benefits for shareholders.
---------------------------------------------------------------------------
\3\ See Section VI.A of the Adopting Release (``Benefits'').
\4\ See Adopting Release, text accompanying note 75.
\5\ See Section VIII of the Adopting Release (Consideration of
Promotion of Efficiency, Competition and Capital Formation'').
\6\ See Securities and Exchange Commission, Open Meeting
Webcast, June 23, 2004 (available at: http://www.sec.gov/news/openmeetings.shtml
) (dissenting views on the value of empirical
data).
---------------------------------------------------------------------------
Existing Independence Requirements Are Sufficient To Ensure
Meaningful Influence
Existing statutory and regulatory requirements already ensure
that independent directors can make their voices heard and heeded.
In enacting the Investment Company Act, Congress prescribed a fund
board's independence requirements. Section 10(a) of the Investment
Company Act requires that at least forty percent of a fund's board
be independent.\7\ Section 10(b)(2) of the Act requires, in effect,
that independent directors comprise a majority of a fund's board if
the fund's principal underwriter is an affiliate of the fund's
adviser.\8\ Moreover, certain board actions cannot be taken without
approval by a majority of the independent directors. Most
importantly, section 15(c) provides that a majority of the
independent directors must approve advisory and underwriting
contracts.\9\ Certain Commission exemptive rules also require a
majority vote by the independent directors in specific areas of
conflict.\10\ In addition, three years ago the Commission
conditioned ten of its commonly-used exemptive rules on fund boards'
having a majority of independent directors.\11\ These rules are the
same rules the Commission is amending today.\12\
---------------------------------------------------------------------------
\7\ See section 10(a). 15 U.S.C. 80a-10(a). Congress initially
considered, but later rejected a majority independence requirement
because of concerns ``that if a person is buying management of a
particular person and if the majority of the board can repudiate his
advice, then in effect, you are depriving the stockholders of that
person's advice.'' Investment Trusts and Investment Companies:
Hearings on H.R. 10065 Before the House Subcomm. on Interstate and
Foreign Commerce, 76th Cong., 3d Sess. 109-110 (1940) (testimony of
David Schenker). Since approximately 90 percent of funds utilize
these exemptive rules, the majority is effectively mandating these
changes for all funds. See Adopting Release at note 88. Given the
clearly stated, legislatively prescribed independence mandates, we
question whether the Commission is acting outside its authority
under the Investment Company Act.
\8\ 15 U.S.C. 80a-10(b)(2). See also section 10(c) (a majority
of the board of a registered investment company may not consist of
persons who are officers, directors, or employees of any one bank or
bank holding company).
\9\ 15 U.S.C. 80a-15(c). See also section 32(a)(1) of the Act (a
fund's auditor must be selected by the vote of a majority of the
fund's independent directors).
\10\ Rule 17a-7, for example, requires that fund directors,
including a majority of the independent directors, determine at
least quarterly that all affiliated purchase and sale transactions
were made in compliance with procedures adopted by the board,
including a majority of the independent directors. 17 CFR 270.17a-7.
\11\ Role of Independent Directors of Investment Companies,
Investment Company Act Release No. 24816 (Jan. 2, 2001) [66 FR 3734
(Jan. 16, 2001)] (``2001 Adopting Release'').
\12\ See Adopting Release at note 8.
---------------------------------------------------------------------------
The existing independence requirements already enable
independent directors to set the agenda and determine the outcome of
[[Page 46391]]
decisions made by the board.\13\ As the Commission noted three years
ago, a majority requirement is sufficient to ``permit, under state
law, the independent directors to control the fund's ``corporate
machinery,'' i.e., to elect officers of the fund, call meetings,
solicit proxies, and take other actions without the consent of the
adviser.'' \14\ ``[I]ndependent directors who comprise the majority
of a board can have a more meaningful influence on fund management
and represent shareholders from a position of strength.'' \15\ A
majority of independent directors also can insist, if they determine
that it would be beneficial, on an independent chairperson.
---------------------------------------------------------------------------
\13\ Last year, the staff noted the power already possessed by
fund independent directors: ``[A]lmost all funds have boards with at
least a majority of independent directors. Thus, one could question
whether there is a need to mandate that a fund's chairman be
independent because independent directors representing a majority of
a fund's board already are in a position to control the board and,
if they deemed it appropriate, could already influence the agenda
and the flow of information to the board.'' Memorandum from Paul F.
Roye, Director, Division of Investment Management, to William H.
Donaldson, Chairman, SEC, re Correspondence from Chairman Richard H.
Baker, House Subcommittee on Capital Markets, Insurance and
Government Sponsored Enterprises, at 50 (June 9, 2003) (available
at: http://financialservices. house.gov/media/pdf/02-14-
70%20memo.pdf) (``Baker Memorandum'').
\14\ 2001 Adopting Release at text accompanying note 22.
\15\ 2001 Adopting Release at text accompanying note 23.
---------------------------------------------------------------------------
We are particularly troubled that the Commission has not shown
that the reforms from three years ago were inadequate to achieve the
stated goals. The new independence conditions took effect on July 1,
2002, so the Commission has allowed itself only two years to observe
the effects of the amendments. Most importantly, the Commission has
not even attempted the barest systematic assessment of the
effectiveness either of those reforms or, more generally, of the
statutory and rule-based fund governance requirements. We are also
troubled that at the same time the majority raises the requirement
for the number of independent directors, it notes that the directors
who are legally ``independent'' may not really be independent.\16\
The majority's concerns suggest a possible need for a change in the
statutory definition of ``interested person'' under section 2(a)(19)
of the Act rather than for an increase in the number of independent
directors.\17\
---------------------------------------------------------------------------
\16\ See Section II.C of the Adopting Release.
\17\ ``Independent director'' is a term commonly used to refer
to a director who is not an ``interested person'' as defined in
section 2(a)(19). 15 U.S.C. 80a-2(a)(19). The Commission, of course,
would need to petition Congress for such a change. Indeed, last year
the staff asked Congress to consider revising section 2(a)(19) of
the Act to give the Commission ``rulemaking authority to fill gaps
in the statute that have permitted persons to serve as independent
directors despite relationships that suggest a lack of independence
from fund management.'' See Baker Memorandum, supra note 13, at 47.
---------------------------------------------------------------------------
A Seventy-Five Percent Independence Threshold Is Unnecessary
The majority's choice of seventy-five percent is puzzling. The
majority points to the only section in the Investment Company Act
that dictates this percentage, section 15(f).\18\ The majority does
not explain that section 15(f) is a safe harbor provision that
``make[s] clear that an investment adviser can make a profit on the
sale of its business subject to two principal safeguards to protect
the investment company and its shareholders.'' \19\ Congress did not
intend for it to serve as a universally-applicable requirement for
fund boards.
---------------------------------------------------------------------------
\18\ 15 U.S.C. 80a-15(f). Section 15(f) requires funds to
maintain boards comprising at least seventy-five percent independent
directors for the three-year period after an adviser has sold its
advisory business to another entity. This provision was added by
Congress to limit the effects of Rosenfeld v. Black, 445 F.2d 1337
(2d Cir. 1971). In that case, the court had held that it was a
violation of an adviser's fiduciary duty to transfer an advisory
contract to another adviser for profit.
\19\ Committee on Banking, Housing and Urban Affairs, Report No.
94-75 to Accompany S. 249 (Apr. 14, 1975).
---------------------------------------------------------------------------
The Commission could have imposed a two-thirds independence
requirement, which most funds already satisfy, is consistent with
best practices recommendations from the Investment Company
Institute,\20\ and was contemplated (but rejected in favor of a
majority requirement) in connection with the 2001 fund governance
changes.\21\ Instead, the majority has chosen a seventy-five percent
minimum, which forces approximately half of funds to make
changes.\22\ Again, the majority fails to give any real
consideration to the costs of this change. The Adopting Release
acknowledges that ``our staff has no reliable basis for determining
how funds would choose to satisfy [the seventy-five percent]
requirement and therefore it is difficult to determine the costs
associated with electing independent directors.'' \23\ Fund boards
are able to avoid incurring the costs of hiring new independent
directors by reducing the number of directors, but even this
approach is likely to impose some costs, not the least of which is
the loss of the insight and experience of directors who are removed
from the board. Funds that conclude that it is in the interest of
fund shareholders to retain existing interested directors will need
to hire additional independent directors, a costly prospect.\24\
---------------------------------------------------------------------------
\20\ See Investment Company Institute, Report of the Advisory
Group on Best Practices for Fund Directors: Enhancing a Culture of
Independence and Effectiveness at 10-12 (June 24, 1999) (available
at: http://www.ici.org/pdf/rpt_best_practices.pdf).
\21\ See 2001 Adopting Release at note 25. The majority,
conceding that ``there are good arguments for maintaining a
management presence on the board,'' portrays itself as reasonable
because it rejected the higher independence percentages recommended
by some commenters. See Adopting Release at note [31] and
accompanying text (citing Letter of Tom Walker to Jonathan G. Katz,
Secretary, SEC (Mar. 9, 2004)), File No. S7-03-04 (``While your
changes are moving in the right direction in advocating for a more
independant [sic] boards. I believe it still allows for too much
room for cornyism [sic] and nepotism to play out on what should be
truley [sic] independant [sic] directors.''); Letter of John and
Judy Hesselberth to Jonathan G. Katz, Secretary, SEC (Feb. 24,
2004), File No. S7-03-04 (``In addition the requirement that 75% of
the directors of a mutual fund must be outside directors is sound.
It probably should be 100%, but 75 is a step in the right direction
from the current 50%.'').
\22\ See Letter from Craig S. Tyle, General Counsel, Investment
Company Institute, to Jonathan G. Katz, Secretary, SEC (Mar. 10,
2004), File No. S7-03-04 (stating that ``a change from the current
[common industry] practice of a two-thirds supermajority to a
seventy-five percent requirement would mean that at least half of
all fund boards would have to change their current composition,
according to Institute data.'').
\23\ Adopting Release at text accompanying note [79] (footnote
omitted).
\24\ A survey found that in 2002, the median compensation for
independent directors at the 50 largest fund groups was $113,000 a
year and at the smaller fund groups was $18,000. See Rick Miller, In
Off Year, these Cats Get Fatter: Fund Board Directors Collect a Big
Pay Raise, Investment News, April 7, 2003, at 1 (reporting results
of a survey conducted by Management Practice Inc.). This amount, of
course, does not include up-front search costs and annual non-
compensation costs associated with a director's performance of his
or her duties.
---------------------------------------------------------------------------
Mandating an Independent Chairperson Is Unwarranted
The rulemaking is characterized as being part of the solution to
the late trading, market timing, and other fund abuses that have
come to light over the past year. Its proponents claim that the
enforcement cases we have brought to date in this area exhibit a
telling pattern--approximately eighty percent of the funds involved
had inside chairpersons.\25\ However, because approximately eighty
percent of all fund firms have interested chairpersons, this number
suggests only that funds with inside chairpersons are proportionally
implicated in the abusive activity. A common feature of these
enforcement actions is that boards were not told of the formal or
informal arrangements permitting market timing. An inside
chairperson with access to information about day-to-day operations
might be more likely than an independent chairperson to discover
practices that are harmful to fund shareholders.\26\
---------------------------------------------------------------------------
\25\ See, e.g., Letter from Congressman Michael G. Oxley to
Chairman William H. Donaldson (May 20, 2004).
\26\ In pointing out this and other potential benefits that an
interested chairperson might bring to a fund board, we do not intend
to suggest that all boards should select an interested chairperson.
To the contrary, we maintain that what works well for one fund board
might not work well for every other fund board. Under certain
circumstances, a fund board might conclude that an independent
chairperson is essential. See, e.g., Tom Lauricella, Strong Steps
Down from Fund Board but Stays on as Head of Firm, Wall St. J., Nov.
3, 2003, at C12 (reporting that following Richard Strong's
resignation from his post as chairman of the board of the Strong
Mutual Funds, ``[t]he independent Strong directors have begun a
search to replace Mr. Strong with a chairman who is independent from
Strong Capital management'').
---------------------------------------------------------------------------
When the amendments were proposed, we asked that a more thorough
analysis be undertaken before effecting these significant changes in
an industry that is of such importance to so many investors.\27\
[[Page 46392]]
Proponents of the rule undertook no such analysis, and the
Commission did not use its resources to conduct such an analysis.
The burden of proof lies with the regulator seeking to overturn the
status quo rather than with the regulated.\28\ The empirical data we
did receive suggest that the amendments might not be beneficial. The
data show a correlation between an inside chairperson and superior
performance and no statistically significant negative effect on
fees.\29\ Indeed, many of the funds that report the best performance
and lowest fees have inside chairpersons.\30\
---------------------------------------------------------------------------
\27\ At the Commission Open Meeting during which the Commission
voted to propose the amendments, Commissioner Glassman requested
that proponents and/or staff provide empirical data that would
support the amendments.
\28\ The application of ``Total Quality Management,'' the
management philosophy of W. Edwards Deming, and a later variant,
``Six Sigma,'' would emphasize the importance of discerning whether
the fund advisers' fraudulent activity (the variation from desired
results) derives from a common cause or something aberrant in a
particular adviser's management process--that is, a special cause.
If common causes are to blame for the fraudulent activity, then the
system is flawed and redesign is necessary. Special causes require
more targeted solutions. As discussed below, the fact that funds
with independent chairpersons seem proportionally implicated in this
fraudulent activity indicates that the lack of an independent
chairperson is not a common cause for the fraudulent activity by
fund advisers. In addition, the empirical data that we have found
this far supports this observation. Consequently, a redesign of the
fund governance system is not indicated by the data. The majority's
redesign of the system will not, and cannot be expected to, cure the
flaws of the system.
\29\ See Geoffrey H. Bobroff and Thomas H. Mack, Assessing the
Significance of Mutual Fund Board Independent Chairs, A Study for
Fidelity Investments (Mar. 10, 2004) (attached to letter from Eric
D. Roiter, Senior Vice President and General Counsel, Fidelity
Management & Research Company to Jonathan G. Katz, SEC (Mar. 10,
2002), File No. S7-03-04)). In an effort to support its position and
rebut challenges that it has not considered any empirical evidence,
the majority laments the fact that commenters did not submit any
pre-existing studies and dismisses the findings of this study, which
was commissioned in response to the Commission's request for
comments on the proposed amendments. See Adopting Release at note
51. The majority's intimation that the data must be discounted
because of the ``prevalence of independent chairmen among bank-
sponsored fund groups'' is troubling if it is intended to suggest
that bank-sponsored mutual funds are inherently inferior to their
non-bank counterparts. We acknowledge that one study cannot
conclusively resolve the debate about independent chairpersons, but
its conclusions contribute to the debate. Boards of directors, not
the Commission, should weigh the evidence to decide whether an
independent chairperson would be beneficial for their fund
shareholders.
\30\ Id.
---------------------------------------------------------------------------
A fact largely ignored by this rulemaking is that independent
directors are not the only ones charged with protecting the
interests of fund shareholders. An investment adviser has a
fiduciary duty to act in the best interests of a fund it
advises.\31\ Further, all fund directors have a fiduciary duty to
shareholders.\32\ It is true that fund managers serve two
constituencies--shareholders of the adviser and shareholders of the
fund. The interests of these two groups are not, however, entirely
at odds. Interested fund directors have an incentive to maximize
fund performance because good performance matters to fund investors,
who factor it into their investment decisions. Thus, market forces
compel fund advisers to offer fund shareholders good performance for
a reasonable fee in order to preserve the integrity and hence,
marketability, of its brand. This rulemaking overlooks these market
forces and seems to suggest that there is no counterweight to the
pressure to impose fees on the fund.
---------------------------------------------------------------------------
\31\ See Rosenfeld v. Black, 445 F.2d 1337 (2d Cir. 1971); Brown
v. Bullock, 194 F. Supp. 207, 229, 234 (S.D.N.Y.), aff'd, 294 F.2d
415 (2d Cir. 1961). See also section 36(b) of the Investment Company
Act [15 U.S.C. 80a-35(b)] (investment adviser of a fund has a
fiduciary duty with respect to the receipt of compensation paid by
the fund). More generally, investment advisers owe a fiduciary duty
to their clients. SEC v. Capital Gains Research Bureau, 375 U.S.
180, 191 (1963) (interpreting section 206 of the Investment Advisers
Act of 1940).
\32\ In addition to standard state law duties applicable to all
corporate directors, fund directors have fiduciary duties under the
Investment Company Act. See section 36(a) of the Investment Company
Act. [15 U.S.C. 80a-35(a)].
---------------------------------------------------------------------------
Concluding nonetheless that investors would benefit from an
independent chairperson, the majority ignores the costs fund
investors will bear by the adoption of this requirement.\33\ The
majority did not identify ``any out-of-pocket costs'' associated
with the independent chairperson requirement. Yet an estimated
eighty percent of funds will need a new chairperson. If a sitting
independent director accepts the position, the fund will need to pay
him more to accept the new responsibilities.\34\ If none of the
sitting independent directors wants the job or none is
qualified,\35\ the fund will need to launch an expensive search. It
may be difficult for funds to find an individual with the requisite
industry experience whom they can afford to hire.
---------------------------------------------------------------------------
\33\ See Section VI.B (``Costs'') of the Adopting Release.
\34\ According to one estimate, an independent chairperson could
command a 25 to 50% premium over other board members. See Beagan
Wilcox, Wanted: Independent Chairmen, Board IQ, July 6, 2004 (citing
estimate of Meyrick Payne, senior partner, Management Practice).
\35\ Independent directors have ``diverse backgrounds in
business, government or academia.'' Investment Company Institute,
Understanding the Role of Mutual Fund Directors, at 6. Fund
independent directors without experience in the fund industry can
apply their experiences in other areas to perform their
responsibilities as independent directors, but may not be adequately
equipped to handle responsibilities of board chairperson.
---------------------------------------------------------------------------
Moreover, in order to be effective at carrying out his or her
responsibilities, an independent chairperson likely would have to
hire a staff.\36\ The majority addresses this issue only in passing
by stating that the ``staff is not aware of any costs associated
with hiring employees or retaining experts because boards typically
have this authority under state law, and the rule would not
require'' that an independent chairperson hire employees.\37\ We
cannot support a rule that rests upon such tortured logic and
circular reasoning. As some commenters have noted, it is ironic that
the majority, in its zeal to strengthen the independence of fund
boards, has enacted a measure that takes away that independence of
the board to select its own chairperson.\38\
---------------------------------------------------------------------------
\36\ Of necessity, both the independent chairperson and his or
her staff are likely to be dependent on fund management and,
therefore, may lose independent perspective on matters facing the
board. Sir Derek Higgs recognized this in his review of corporate
governance in Britain. See Derek Higgs, Review of the Role and
Effectiveness of Non-Executive Directors (Jan. 2003) at 24
(explaining that, even if a chairperson is independent prior to
appointment, thereafter he or she will work closely with management
in carrying out his or her duties, so ``[a]pplying a test of
independence at this stage is neither appropriate nor necessary.'').
\37\ See Section VI.B (``Costs'') of the Adopting Release.
\38\ The majority reassures independent directors that the
amendments ``do not prevent the independent directors from choosing
the most qualified and capable candidate.'' See Adopting Release, at
text following note 47. We contend that a conscientious board might
reasonably determine that the most qualified and capable candidate
is someone with the deep familiarity with day-to-day fund
operations. The majority apparently believes they know better.
---------------------------------------------------------------------------
The Commission Failed To Examine Alternatives
We fear that the Commission is acting simply to appear
proactive. The Commission already has taken significant steps to
address the recently uncovered abuses in the fund industry and to
identify and address other potentially problematic issues. We have
brought enforcement actions under existing laws and regulations to
punish the wrongdoers.\39\ We have also initiated meaningful
regulatory reform. Recently, for example, we adopted requirements
regarding the disclosure of market-timing policies,\40\ enhancing
the disclosure provided by funds about how their boards evaluate and
approve investment advisory contracts,\41\ and requiring funds and
advisers to designate chief compliance officers.\42\ In addition, we
are considering initiatives on fair value pricing,\43\ increased
transparency of fund transaction costs and expenses,\44\ pricing of
[[Page 46393]]
fund shares,\45\ and fund distribution arrangements.\46\
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\39\ See Adopting Release at note 5.
\40\ Disclosure Regarding Market Timing and Selective Disclosure
of Portfolio Holdings, Investment Company Act Release No. 26418
(Apr. 19, 2004) [69 FR 22300 (Apr. 23, 2004)].
\41\ Disclosure Regarding Approval of Investment Advisory
Contracts by Directors of Investment Companies, Investment Company
Act Release 26486 (June 23, 2004) [69 FR 39798 (June 30, 2004)].
\42\ Compliance Programs of Investment Companies and Investment
Advisers, Investment Advisers Act Release No. 2204 (Dec. 17, 2003)
[68 FR 74714 (Dec. 24, 2003)].
\43\ These initiatives are described in Mandatory Redemption
Fees for Redeemable Fund Securities, Investment Company Act Release
No. 26375A at Section II.F (Mar. 5, 2004) [69 FR 11762 (Mar. 11,
2004)].
\44\ See Confirmation Requirements and Point of Sale Disclosure
Requirements for Transactions in Certain Mutual Funds and Other
Securities, and Other Confirmation Requirement Amendments, and
Amendments to the Registration Form for Mutual Funds, Investment
Company Act Release No. 26341 (Jan. 29, 2004) [69 FR 6438 (Feb. 10,
2004)] and Request for Comments on Measures to Improve Disclosure of
Mutual Fund Transaction Costs, Investment Company Act Release No.
26313 (Dec. 18, 2003).
\45\ Amendments to Rules Governing Pricing of Mutual Fund
Shares, Investment Company Act Release No. 26288 (Dec. 11, 2003) [68
FR 70388 (Dec. 17, 2003)].
\46\ Prohibition on the Use of Brokerage Commissions to Finance
Distribution, Investment Company Act Release No. 26356 (Feb. 24,
2004) [69 FR 9726 (Mar. 1, 2004)].
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We were hopeful when these board governance amendments were
proposed that alternative measures would be considered. Requiring a
fund to disclose prominently whether or not it had an independent
chairperson, for example, would allow shareholders to decide whether
that matters to them or not. Alternatively, we could have endorsed
the lead independent director concept by requiring a fund's
independent directors to appoint a lead director to represent the
views of the fund's independent directors to fund management.\47\ We
could have required additionally that each major board committee be
chaired by an independent director, who would have the authority to
set the agenda of the committee. The advantage of these
alternatives, in addition to being less costly, is that they leave
the decision about the independent chairperson to the independent
directors or the marketplace, rather than impose the requirement by
regulatory fiat. The majority failed to give serious consideration
to these alternatives.\48\
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\47\ In 1999, the Investment Company Institute's Advisory Group
on Best Practices for Fund Directors included among its
recommendations the designation of one or more persons as a lead
director. See Investment Company Institute, Report of the Advisory
Group on Best Practices for Fund Directors: Enhancing a Culture of
Independence and Effectiveness at 25 (June 24, 1999) (available at:
http://www.ici.org/pdf/rpt_best_practices.pdf).
\48\ The majority acknowledged that these alternatives could be
useful, but explained that funds would have difficulty finding
persons of ``sufficient stature'' to act as ``an effective
counterweight to a fund chairman who may also be the chief executive
officer of the management company.'' See Adopting Release at text
accompanying note 57. We question whether funds will find it easier
to fill the position of independent chairperson with a person able
both to act as an ``effective counterweight'' and also to fulfill
the routine administrative responsibilities of running a fund board.
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Under the cover of ``good atmospherics'' and the shroud of
``investor protection,'' the majority has decided to adopt measures
the benefits of which are illusory, but the costs of which are real.
We conclude that the majority has not justified this forced
restructuring of the corporate governance of the vast majority of
funds and fear that it provides investors with a false sense of
security.
For the foregoing reasons, we respectfully dissent.
Cynthia A. Glassman,
Commissioner.
Paul S. Atkins,
Commissioner.
[FR Doc. 04-17460 Filed 7-30-04; 8:45 am]
BILLING CODE 8010-01-P