Remarks to the Independent Directors Council Annual Fall Meeting
Director, Division of Investment Management
U.S. Securities and Exchange Commission
Oct. 22, 2013
Good afternoon. Thank you, Susan, for your kind introduction, and thank you for inviting me to speak at the Independent Directors Council Conference today. Before I continue, let me remind you that the views I express are my own and do not necessarily reflect the views of the Commission, any of the Commissioners, or any of my colleagues on the staff of the Commission.
It is a privilege to appear before a group that is so important to the strength and integrity of the fund industry. Independent directors have significant responsibilities, and it requires tremendous effort and time on your part to do your job well. I applaud your efforts to learn from the professionals who are participating in this conference. The insights of the panels you heard yesterday and this morning, and those you will hear after lunch will provide valuable information.
The importance of mutual funds in the lives of American investors is clear. Mutual funds hold close to $14 trillion of the hard earned savings of over 53 million American households. The majority of Americans access the markets through mutual funds. They invest in funds, and hope their investments will grow, for many reasons -- to make a down payment on a house, to save for a college education, and ultimately to pay for a retirement.
The Commission’s mission in this landscape is clear. It is charged with protecting investors, ensuring fair and orderly markets, and promoting capital formation. Every one of us in the Division of Investment Management takes seriously how our work fits into that mission. Indeed, our mission statement was drafted with the help of the entire Division. In drafting our mission statement, we wanted to determine how our efforts fit in the overall SEC mission. And we agreed that we work to protect investors, promote informed investment decisions, and facilitate appropriate innovation in investment products and services through regulating the asset management industry. As I consider the Division’s mission, I see common themes to our mission in the role that independent directors play. Although you do not regulate the asset management industry, you are first and foremost “independent watchdogs.” As watchdogs, you oversee funds to protect the shareholders you serve. You also help facilitate innovation in new products that are designed to meet investor needs. And you monitor the information your funds provide that helps investors make informed decisions.
Today I want to talk about our common purpose, and how we can work together to advance it. Specifically, I will talk about the key role communication can play in helping us collaborate to protect investors. First, I will focus on your role in overseeing funds and how it complements ours at the Commission. Then I will discuss developments in our efforts to oversee the industry. Finally, I will highlight how we are striving to improve communication with you to support the mission that we share.
The Role of Independent Directors
Like any corporate director, mutual fund directors must abide by the duties they owe to shareholders under state law. That is, they are subject to the state law duty of care and the duty of loyalty. The duty of care requires independent directors to act with the care that an ordinarily prudent person in a similar position would use under similar circumstances. In satisfying the duty of care, directors should be well informed. They also should base their decisions on reasonable diligence. Your duty includes overseeing corporate management and overseeing service providers. Your oversight includes asking questions when there are red flags.
Under the duty of loyalty, a director must place the best interests of the corporation and its shareholders before his or her own interests or those of anyone else, whether it is a person or an organization. As the Delaware Supreme Court has stated, “[a] director cannot act loyally towards the corporation unless she acts in the good faith belief that her actions are in the corporation’s best interest.” Directors stand in a fiduciary relationship to the corporation and its shareholders. This relationship requires directors not only to protect the interests of the corporation and its shareholders, but also to refrain from doing anything that would cause injury to the corporation.
In fulfilling their obligations, mutual fund directors must apply those general state law principles in the context of the specific responsibilities and restrictions imposed under the federal law. Federal law doesn’t generally preempt state laws that govern the powers of corporate directors. But federal law does preempt state law if the state law permits action that federal law prohibits, or if the application of state law would be inconsistent with the federal policy underlying the federal cause of action. Because of the “extensive layering” of federal regulation under the Investment Company Act, “fund directors must, as a practical matter, consider their responsibilities under state law as inextricably linked to those under federal law.”
Under the Investment Company Act, as independent directors, you have express duties in the governance of mutual funds. These responsibilities arise because mutual funds are formed and operate so differently from other corporations. As you well know, conflicts are inherent in a fund’s structure. The potential for abuses are ever present because the fund is organized by a sponsor -- an investment adviser -- whose primary loyalty and financial interests lie outside the fund, and because third parties provide all the services that allow the fund to operate, including investment management, distribution and custody.
Congress gave fund directors, and particularly independent directors, specific responsibilities to address the conflicts of interest that arise because of the way funds are formed and operate. Under the Investment Company Act, you are the “independent watchdogs” for shareholder interests by being a check on management. You address the potential for abuse that accompanies those conflicts of interest.
Your responsibilities under the Act flow from the same underlying purpose as do your duties under state law -- to protect the fund’s shareholders. The purpose underlying the Commission’s responsibilities is the same. To achieve our common mission of protecting investors, we both oversee funds, but in different ways. While you are on the front lines overseeing the funds you serve, we are monitoring the entire fund industry.
Division Improvement Initiatives
As the investment landscape changes, with evolving investor needs and new products designed to meet those needs, we as regulators are challenged every day -- to provide effective oversight and to protect investors. And in the Division, we are working to meet those challenges. We are focusing our energy, trying to become smarter, more strategic and more targeted.
One area where we have spent a lot of time focusing our energy is on rulemaking initiatives. To ensure that we are allocating our resources wisely, over the past year, we have taken a fresh look at policy initiatives with a view to analyzing those matters based on four factors: First, the risk to be mitigated; Second, the urgency associated with a particular initiative; Third the potential impact of an initiative on investors, registrants, capital formation, efficient markets, and the Division’s and the SEC’s operational efficiency; and Fourth, the resources associated with a policy initiative. We’re looking at factors that we believe would further the SEC’s mission as well as the impact that various regulatory initiatives would have on investors, capital formation, and efficient markets. The analysis has helped to inform the Chairman, in collaboration with the Commissioners, in her determination of which regulatory priorities the Commission will pursue.
I am pleased to report that we have completed the first of the priorities that we identified early this year. In April, the Commission adopted the “Identity Theft Red Flags Rules” -- rules to detect and prevent theft of the identities of mutual fund investors and clients of asset managers. I want to mention two other regulatory projects that the staff is focused on now. The first is additional money market fund reform. As I’m sure you know, the Commission proposed additional money market fund reforms in June. The comment period officially closed on September 17, although we continue to receive comments. The staff is currently reviewing and analyzing the more than 1300 letters we have received to date.
Another rulemaking initiative we’re focused on involves ETFs. In 2008, the Commission proposed a rule that would basically codify certain exemptive relief that we routinely grant for these funds. The proposed exemptive rule would have allowed certain ETFs to launch without having to file an exemptive application -- a process that, while important for novel products, can be costly and time-consuming. If ETFs of new sponsors could come to market without having to obtain their own exemptive relief, the Division could reallocate staff resources from the review of these “plain vanilla” applications to more novel applications. The Division is considering how to advance consideration of this type of ETF rule.
In our efforts to work smarter, we also focused on the Division as a whole. During the past year, we began a process to better understand our strengths and areas for improvement. Enhanced communication and collaboration are key elements of that initiative. We gathered input from inside the Division as well as from our colleagues throughout the Commission. We identified and prioritized issues confronting the Division and created teams of managers and staff to address these issues. These teams have made recommendations, and I am pleased at the number of creative ideas that were generated. As a result, we have implemented a number of initiatives, which are designed to – First, encourage an inclusive collaborative working environment within IM, across the Commission, and with outside stakeholders. Second, increase information and knowledge sharing. And third, provide transparency into our work processes.
An important tool in our efforts to increase communication and collaboration is our newly created Risk and Examinations Office, or “REO.” REO supports the Division’s work primarily through two functions. REO is a multi-disciplinary office staffed with analysts with strong quantitative backgrounds, along with examiners, lawyers and accountants. REO maintains an industry monitoring program that provides ongoing financial analysis of the investment management industry. In particular, REO is charged with monitoring activities of investment companies, investment advisers and investment products. REO intends to conduct rigorous quantitative and qualitative financial analysis of the investment management industry, with a particular focus on strategically important investment advisers and funds. The REO monitoring program’s work includes analysis of the information the industry provides through various regulatory reports, including Form ADV, the form that investment advisers use to register with the Commission, Form PF, the form that certain investment advisers to private funds use to report risk data, and Form N-MFP, the reporting form that money market funds use to report their portfolio holdings and other key information. REO also draws on industry information from third party providers. In addition, REO conducts an examination program that gathers additional information from the investment management industry to inform the Division’s policy making. Although REO may conduct its own exams, where practical, REO will join examiners from the Commission’s Office of Compliance Inspections and Examinations (OCIE) on their examinations of firms. So far all REO exams have been in association with OCIE.
All of REO’s work will inform the initiatives to which the Division devotes resources and will help inform the rules we are drafting.
I am excited at the prospect that REO can help the staff to be proactive and get out in front of new industry trends, rather than reacting to past practices. We hope to use the work of REO to make our oversight more efficient and effective. REO represents a new area of focus for the Division of Investment Management, and I expect REO to complement the work of the SEC as a whole.
I also believe that we can make REO even more effective with enhanced information. We are working to do this in two ways. First, we are seeking to be more in tune with industry developments and investors’ experiences. This effort involves getting a better and more first-hand understanding of the workings of the investment management industry through meeting with fund boards and senior fund management. I will talk more about this in a moment.
Second, we are working to enhance REO and the Division’s ability to collect and analyze data. As you know, as part of the money market fund reforms adopted by the SEC in 2010, we now receive monthly data on money market fund portfolio holdings through Form N-MFP. This new data has been extremely valuable. We are able to use it to monitor trends, identify outliers and better inform our rule-writing efforts. What we don’t have, however, is similar information on other mutual funds, closed-end funds and ETFs. Instead, we have a hodgepodge of data collection and reporting forms with outdated technology behind them. These forms provide only a patchwork of data that does not tell us detail about mutual funds but often allows rounding and summary information. That is why Division staff is undertaking an initiative to consider potential ways to streamline the fund reporting forms and develop reporting for funds other than money market funds that could give us timely and accurate information about their operations and portfolio holdings.
In addition to our focus on communication within the Division, we are working on better communication with our colleagues throughout the Commission. For example, we have worked intentionally towards better coordination and cooperation with other offices in connection with major initiatives, doing this as an integral part of the process, rather than a late stage check-in with another office after the essential work on the matter has been completed. This involves comparing notes with others on our initiatives early and often, and seeking meaningful substantive input at all stages of a major undertaking like a rulemaking.
We are also working to enhance our communications with the outside. To further this goal, we are issuing guidance updates in addition to our traditional no-action and interpretive letters. A recent example that may be of interest to fund directors addresses the merger of two affiliated exchange traded funds – a transaction that is generally not covered in the exemptive orders that the Commission issues to ETFs and their advisers in response to applications. The guidance provides staff views regarding such a merger that is executed in accordance with the Commission’s exemptive rule permitting fund mergers and where all applicable disclosure and other requirements are met.
The staff also has issued guidance on complying with the representations and conditions of exemptive orders issued to funds and advisers. The staff noted that funds risk violating the federal securities laws if they fail to comply with the conditions and representations in their orders. The guidance observed one way to address those risks, and offered approaches on how a fund’s compliance program might address conditions relating to board of directors’ review.
The staff’s guidance and issues of interest are posted on the Division’s recently redesigned website. They are easy to find on the Guidance Updates section, which we are using to get more information out quickly. In addition, the IM website has a section that highlights the Division’s current news, which makes it easy to find the most recent guidance.
Communication and Support on Fund Governance
I have just outlined several ways in which we are working toward continuous improvement in the Division, including how we oversee funds. As independent directors, you have a special perspective that makes your oversight different from but complementary to ours. You are monitoring the funds you serve rather than the entire industry, and you best understand those funds. You know the funds’ investment objectives and thus the shareholders’ expectations. You scrutinize the funds’ advisory contracts and fees. You oversee fund distributions, the valuation and pricing of fund shares, custody arrangements, securities lending, and many other fund activities. You confer regularly with fund management. You are on the front lines, seeing new developments and troubleshooting problems as they arise. As a result of all your interactions, you are closer to the needs of investors than we can be and you are better positioned to understand how best to serve their interests. Just as I expect the Commission will benefit from the work that REO will do, I believe that we already benefit from the work of independent directors. And to help you be the most effective in your work, we want to do what we can to support you.
Our interest in this collaboration is not new. The Division and the Commission have considered fund governance and have engaged with independent directors on how to maximize their value over many years. For example, more than twenty years ago, in 1992, the staff reviewed the role of independent directors. It concluded that the governance model embodied in the Investment Company Act is sound, and that the “watchdog” function you perform has served investors well at minimal cost. But the staff also recognized that independent directors faced increasing responsibilities, and so it made recommendations, many of which were adopted by the Commission, to reduce those responsibilities that involved more ritual than substance.
Several years later, in 1999, the Commission held a roundtable devoted to examining the role of independent directors. Many recommendations emerged from the roundtable on ways to improve the mutual fund governance structure. Following the roundtable, the industry and the Commission both worked to enhance the role of independent directors. In June 1999, the ICI’s Advisory Group on Best Practices for Fund Directors published a report identifying best practices for fund boards to enhance the independence and effectiveness of investment company directors. And I note the success of that effort because by 2003, a significant portion of mutual funds had followed all or most of the recommendations of that report. In November 1999, the Commission proposed rule changes, which it adopted in 2001, “designed to reaffirm the important role that independent directors play in protecting fund investors, strengthen their hand in dealing with fund management, reinforce their independence, and provide investors with greater information to assess the directors’ independence.”
More recently in 2007, one of my predecessors as Division Director began a series of meetings designed to determine what the Commission and its staff could do to enable fund directors to be more effective in their oversight role. We gained valuable insights in these meetings, and learned how we might be able to assist directors. For example, in response to concerns we heard, the Division issued guidance on approaches a fund board could take regarding determinations they must make when they perform their quarterly review of certain transactions permitted under our exemptive rules.
This type of communication, I believe, is essential to a successful collaboration. I mentioned earlier that the Division has been reaching out to boards of directors and senior fund management. Our meetings with the industry have started with the largest or most strategically important funds. We have identified a number of potential firms, and at this point we have conducted a number of visits. Our outreach will extend to other funds as well. In these discussions, we want to learn from directors and fund management about specific fund risks and how they manage those risks. We also want to know what you perceive to be the critical risks to the industry as a whole. I have been joined by REO in these meetings because we believe this information will further inform REO’s work, and REO’s work in turn will inform the initiatives to which the Division devotes resources and the rules we are drafting.
I think that the conversations between us can be the most productive when we can speak with you and your fund management directly and get to know you better. To illustrate our commitment to the process, we have met with fund management and boards at their headquarters.
These meetings allow us to obtain a first-hand view of the systems, controls, personnel, and even a sense of the culture of an individual firm. And we find we can learn more about a firm’s business operations by seeing the board and fund management at their offices. We will be better regulators to the extent that we better understand the workings of the industry we regulate. And if you and fund managers see our willingness to reach out and to listen, we hope you and they will respond with increased cooperation and more effective communication.
The discussions we have had with fund management and directors to date have already borne fruit. Boards have shared with us their different perspectives on a variety of issues, including risk management, valuation and compliance, and how those perspectives inform many of their fund practices. Those perspectives help us understand the different methods that might be brought to bear in addressing pressing fund issues and implementing compliance programs. And in turn, if it’s appropriate we are sharing the good practices that we learn about from one firm with other funds.
In addition, we encourage directors to share with us ways in which the Division could help them be more effective. If we hear ideas in our meetings on where you need additional guidance or where you have uncertainty about the law, we will work diligently to get the appropriate guidance out there.
We will continue to seek ways in which we can provide guidance or otherwise assist fund boards, and particularly independent directors, in fulfilling their duties. This is one way we can better serve the public and industry participants.
I look forward to future meetings as our initiative advances. I am particularly glad to have an opportunity today to share views with you and receive feedback. In addition, as I have mentioned, the Division’s door is open, and we want to hear from you what we can do to help make you more effective. Working together, we are better positioned to accomplish our common mission of protecting investors.
Thank you for your time today.
 The Securities and Exchange Commission, as a matter of policy, disclaims responsibility for any private publication or statement by any of its employees. The views expressed herein are those of the author and do not necessarily reflect the views of the Commission or of the author’s colleagues on the staff of the Commission.
 See Investment Company Institute (“ICI”), Trends in Mutual Fund Investing August 2013 (http://www.ici.org/research/stats/trends/trends_08_13); ICI, Profile of Mutual Fund Shareholders 2013, available at (http://www.ici.org/pdf/rpt_13_profiles.pdf).
 Edward Brodsky & M. Patricia Adamski, Law of Corporate Officers and Directors:Rights, Duties and Liabilities 6 (2013).
 Graham v. Allis-Chalmers Mfg. Col, 188 A.2d 125, 130 (Del. Ch. 1963); see also Shenker v. Laureate Educ. Inc., 983 A.2d 408, 419 (Md. 2009).
 See Aronson v. Lewis, 473 A.2d 805, 812 (Del. 1984).
 See Robert A. Robertson, Fund Governance: Legal Duties of Investment Company Directors § 2.04 (2011) (“Fund Governance”).
 See id., at § 2-04[b](ii); see also Graham, 188 A.2d, at130.
 See, e.g., Cede & Co. v. Technicolor, Inc., 634 A.2d 345, 361 (Del. 1993), modified on reargument, 636 A.2d 956 (Del. 1994).
 Guttman v. Huang, 823 A.2d 492, n.34 (Del. Ch. 2003).
 Guth v. Loft, 5 A.2d 503, 510 (Del. 1939).
 Burks v. Lasker, 441 U.S. 471, 486 (1979).
 Id. at 479.
 Fund Governance, supra note 6, § 2.01.
 Money Market Fund Reform; Amendments to Form PF, Investment Company Act Release No. 30551 (June 5, 2013), 78 FR 36834 (June 19, 2013), available at http://www.sec.gov/rules/proposed/2013/33-9408.pdf.
 Exchange-Traded Funds, Investment Company Act Release No. 28193 (Mar. 11, 2008), 73 FR 14618 (Mar. 18, 2008), available at http://www.sec.gov/rules/proposed/2008/33-8901.pdf.
 Merger of Two Exchange-Traded Funds, IM Guidance Update No. 2013-06 (Sept. 2013), available at http://www.sec.gov/divisions/investment/guidance/im-guidance-2013-06.pdf.
 Compliance with Exemptive Orders, IM Guidance Update No. 2013-02 (May 2013), available at http://www.sec.gov/divisions/investment/guidance/im-guidance-2013-02.pdf.
 Division of Investment Management, Protecting Investors: A Half Century of Investment Company Regulation 253 (1992), available at http://www.sec.gov/divisions/investment/guidance/icreg50-92.pdf.
 Investment Company Institute, Report of the Advisory Group on Best Practices for Fund Directors: Enhancing a Culture of Independence and Effectiveness (June 24, 1999), available at http://www.idc.org/pdf/rpt_best_practices.pdf.
 See Richard M. Phillips, Mutual Fund Independent Directors: A Model for Corporate America?, Investment Company Institute Perspective, Aug. 2003, at 3, available at http://www.ici.org/pdf/per09-04.pdf.
 Role of Independent Directors of Investment Companies, Investment Company Act Release No. 24816 (Jan. 2, 2001), at paragraph preceding section I [66 FR 3759 (Jan. 16, 2001)].
 See Staff Letter to the Independent Directors Council and the Mutual Fund Directors Forum (Nov. 2, 2010), available at http://www.sec.gov/divisions/investment/noaction/2010/idc-mfdf110210.pdf.