The Role of Independent Investment Company Directors - Part 2

Transcript of the Conference on the Role of
Independent Investment Company Directors

Opening Remarks 

Mr. Roye:  I would like to welcome you to our second day of the directors' roundtable. I appreciate your being here. I recognize that the weather didn't cooperate with us this morning, but I think you're in for a treat today. We've got some interesting panels focusing on, again, key issues facing independent investment company directors. Let me remind you again that the press is present. Any remarks will be considered on the record. And we look forward to an interesting discussion. I'll turn it over to Barry.

Fund Disclosure and Communications 

Mr. Barbash:  Thank you, Paul. For those of you who may not remember, I used to be Barry Barbash. This morning, our panel will be discussing the role of independent directors in the effort to improve fund disclosure and communications to shareholders. Improving disclosure has been and undoubtedly will continue to be a central theme of the Commission's division of investment management's program. I am joined on the panel today by an experienced group of panelists with diverse backgrounds. Sitting immediately to my left is Norm Smith, a retired lieutenant general in the United States Marine Corps and an independent director of the John Hancock Funds. Seated next to Norm is Mickey Roth, who is the CEO of USAA Investment Management Company, one of the better known mutual fund companies in the United States. Seated next to Mickey is Don Dick, managing principal of Euro Capital Partners, a private equity investment and management advisory firm. Don is a long-time director of the T. Rowe Price funds. Seated next to Don is Bob Denham, a partner in the California-based firm of Munger, Tolles & Olson. He was formerly chairman and chief executive officer of Solomon, Inc. Bob is what I refer to as the panel's outside legal expert. He is not a practitioner in the investment management area. Some would say that's refreshing. But he is a quite well-known and respected expert in the securities law area. And then, seated next to Bob is Jay Baris, a partner in the New York City firm of Kramer, Levin, Naftalis & Frankel. Jay is the panel's inside legal expert. He's a specialist in the investment management area and is one of the more prolific writers of the investment management bar.

We are going to follow the format that was used generally yesterday. Each of the five panelists will give a short statement at the beginning, and then we will follow with questions and answers. I want to make a couple of preliminary observations. One is that we are following the principle of moderator immunity. There will be no attacks against the moderator in anything he did or didn't do in his previous life. I want to thank sincerely the two SEC staff people who had to put up with schedules that were evolving all the time, had to put up with my schedule. They had to come visit my offices at weird times to try to get me materials. And I want to thank Jennifer Choi and Heather Seidel. Jennifer won a lottery to be the person who manages this panel. I understand that they were lining up in the Division of Investment Management to see who could do this to me at the end of the panel. One other last observation, and perhaps the most important, is the one thing you can about this panel is that it is the tallest panel, and we are well positioned for the intramural basketball game that will be played after this.

(Laughter.)

(Laughter.)

The independent directors were periodically briefed as the project matured. We were given various drafts. We, the independent directors, were given various drafts as the project went along, and we made our inputs. The diversity on our own particular board, the various occupations that we have there, I think lent itself to working on this plain language challenge. At any rate, the drafts were often reviewed. Focus groups looked at them. Lawyers looked at them. Marketing looked at them. Advertising, and all the other various wire diagram blocks in John Hancock Mutual Funds looked at them to make sure that it was doing what we expected it to do. We found that it took real teamwork from the independent directors and the management, and the enthusiasm to get on with this particular project.

The independent directors agreed to accept some of the costs of this project, as well. We feel that that was money well spent toward developing it. The prospectus itself, for all you sharp-eyed folks, here's one example here: growth funds. And we wrote these prospectuses so that they encompassed all the funds that were in that particular style. For example, here, growth funds has some seven mutual funds in it. They worked very hard to make sure it was a large enough document that was easily read, the legend and the little icons in it are consistent throughout. The hiring of an outside writer was a great benefit – who was not a lawyer, by the way. We have received a considerable amount of accolades from shareholders, from the public in general. I think the SEC was fairly satisfied with the final product that came out of here. We had a couple complaints. One of them, one broker said that, in putting all of the mutual funds under one cover made it too difficult to sell a particular mutual fund because the clients were always shifting to another page and looking at it. Another broker grumped that the large-page, magazine-style size made it too hard to mail. Other than that, I haven't heard too much complaints about this particular product. At any rate, I can just emphasize that it takes teamwork to get the job done. Independent directors play an important role in it, as does the SEC. And I really laud the project to any of my independent director colleagues here in the audience. If you haven't embarked on this project, it is probably worthwhile getting after. Thank you, sir.

Mr. Barbash:  Mickey, your organization also went through the process of developing an enhanced, better prospectus. Can you speak about that?

Mr. Roth:  We certainly did. And I want to start off also by thanking Chairman Levitt for the invitation to be here. It is a pleasure to be here. It's also nice to follow General Smith. He's probably the only gentleman in the room who has been a member of USAA longer than I have. It was about three years ago, I was in Washington at a dinner in conjunction with the ICI annual meeting, where I sat next to Nancy Smith, and she mentioned that the SEC was going to begin working on a plain English prospectus. I immediately volunteered our help with that. This is something that was very close to our hearts at USAA. The fund industry has had a remarkable history in about the last 10 or 15 years, coming from far nowhere among financial intermediaries to become the premier way that Americans invest and save. There's a great trust there. The basic form of mutual funds is a good form. Unlike other intermediaries who, in the time that I've been in this business, have gathered great amounts of assets under management and then practically disappeared, the fund industry has one structural advantage and beauty to it. And that is, every day, as best we can, we tell you exactly what it's worth, and we provide great liquidity and we provide great service. A great trust has grown up with the American people, and people in other parts of the world, too, toward the fund industry. And it is essential, those lessons of other intermediaries that have come and gone tell us that we need to be careful, and we need to nurture that trust, and this plain English effort is a major way that we can do that.

As General Smith mentioned, the neighbors in Virginia, our folks who are USAA members are not always tremendously sophisticated or knowledgeable about financial instruments, and they need to be given as good a grounding as we can in just what it is they're buying and what they can expect from the financial product that they've purchased. When we set about to construct our plain English prospectus, first of all, we used our own people. And this was an effort among our marketing people, our legal people, our compliance people, and others in our organization. They worked very closely with Nancy Smith and her group, made a number of trips to Washington, and produced a product which we are very, very pleased with. In our case, because it was our own people who were already associated with our company and with our funds, the incremental expense to our funds of this effort was minimal.

An important point about the plain English prospectus, and about the only discouraging words that I've heard about it were concerns by, by some of my colleagues in the fund industry about the possible loss of protection for the companies, the liability question, that could occur by departing from time-tested, albeit stilted, language that has stood the tests of court. The thing that we found is that, with the inclusion of all parts of our company, the legal and compliance especially, that we could write a document that was complete, that covered, we believe, all the subjects that had to be covered. One of the things we learned is that plain English does not mean shorter. In fact, our plain English prospectuses are longer than our previous prospectuses. But, as in the case of John Hancock, as General Smith pointed out, for the first time in my 20 years at USAA, we received letters and calls from people who said that they enjoyed the prospectus.

(Laughter.)

Mr. Barbash:  Don?

Mr. Dick:  Thanks, Barry. Good morning all. In the couple of minutes that I have this morning, I would like to discuss the topic of disclosure and communication using a relatively wide-angle lens, and attempt to place it within the context of today's independent directors' duties and priorities. In the 19 years I've been a fund director, the business has changed from a small industry to what Chairman Levitt has termed a cornerstone of American investment. This change has manifested itself in several important ways that should be known to all of us in this room. However, my view is that, notwithstanding this broad industry change, directors' primary responsibilities will continue to evolve from the core responsibilities originally intended in the Investment Companies Act, however significantly they may be expanding in scope and complexity and however more important the requirement for a more informed director. Updated for today, I would like to define them broadly as setting the terms of the relationship between the adviser sponsor on the one hand, and the funds and its shareholders on the other, and assessing the ongoing capability of the adviser sponsor to carry out its mission. The areas of our specific focus should include investment performance, availability and quality of service, availability and quality of communications, the cost- effectiveness of each and all of these, and the ongoing ability of the sponsor to provide the services. The proper context in which I believe directors should evaluate matters of disclosure is within that focus area that I've called the availability and quality of communications. Matters that fit properly within this area include traditional disclosure matters, such as fund strategy, continuity of management, historical performance, risk, and expenses.

In addition, they may include service and communication capabilities, the array of growing information and communication techniques available to the shareholder, general market advisory information, and matters involving the sponsor, that impact the funds directly. Given the number of funds and the proliferation of strategies in the evolving shareholder mix, and so forth, it is appropriate and even necessary that the industry address the issue of quality and simplification of its communications on a continuing basis. Plain English, on profiles, individual fund initiatives, two of which we have heard about here this morning, are certainly necessary and very constructive steps, in what should be an ongoing industry process. In conclusion, I would like to put a couple of cautionary notes to that process. First, like so many things in our wonderful system, a not so wonderful thing, litigation, also follows the money. Initiatives to simplify and clarify must, therefore, somehow always mesh with the need to provide adequate disclosure, particularly with regard to matters that may involve material risk. Second, the line between what should be required disclosure and what is simply useful is sometimes blurred, and is always shifting. However, wherever and whenever possible, communications and disclosure should be market driven, and not regulation imposed. In this regard, the industry's best interests will be served by its regulators continuing to seek open and frank dialogue in the pursuit of new solutions and directions, and using the bully pulpit, before the word processor. Thank you.

Mr. Barbash:  Bob?

Mr. Denham:  Chairman Levitt, thank you for this opportunity to participate in the conference. America is blessed with a strong competitive and diverse mutual fund industry. How well this industry serves investors depends critically on the ability of investors to make rational choices among the rich diversity of funds that are available to them. This ability in turn is critically effected by the quality of disclosure because disclosure involves conflicts between the adviser's interest in maximizing profits and the investor's interest in being able to make the best choices. Directors, particularly independent directors, have a critical role to play in the disclosure process. When we talk about disclosure I think there's a temptation, perhaps partly lawyer-driven, to focus on the prospectus. The prospectus, of course, is the basic disclosure document. But as a practical matter, to the extent investors look at anything they're more likely to look at profiles, and I think increasingly the profiles that they access on the web, than to look at the prospectus. So directors should pay attention to those profiles in the same way they pay attention to the prospectus. In looking at how to improve disclosure I take a fairly simply approach. I think about what I would want to see as an investor in being able to improve my ability to make choices. There are two areas that matter, one is performance and one is the investment approach of the adviser. The first one is relatively easy to talk about because performance can mostly be expressed numerically.

Funds in America do a particularly good job particularly when you compare them with most of the rest of the world in following a standardized format, a fairly standardized format, for giving performance data. There is, however, one very big hole in the US performance disclosure scheme, and that is disclosure of tax-effected data. For many funds the tax-effected data are not – are not that relevant for some funds but for actively managed growth funds tax-effected data is necessary for investors to make a rational choice if they are investing with taxable funds. The objection has often been made that it's hard to give this kind of data because every investor has a different tax situation. That simply makes it a little bit more complicated but not very complicated. One can provide tax- adjusted performance data at a zero percent rate covering probably about two thirds of accounts that are non-taxable money. A 25 percent rate, a 35 percent rate, and a 45 percent rate and then it's pretty – and then either you have a rate that's quite close to yours on the table or by simple interpolation you can get pretty close to what the performance would be for someone at your rate. A second area where I think performance data can be improved is with respect to risk because performance – good performance – what we're really looking for is obtaining the best performance at moderate levels of risk. If you can maximize performance and do so by taking a little bit less risk than another fund with similar performance you would like to choose the fund with the best performance and the lower risk.

Disclosure of risk data is complex – is somewhat complex to explain to investors. That's where the role of intermediaries come in who can take the data that funds disclose and interpret that in ways that investors can better use. Many funds – I went this weekend in preparation for this I went on the Internet to look at web sites of some funds. Many funds are giving very good risk data and giving pretty good explanations of it. I think funds that – for which their risk profile is a competitive advantage ought to look at that disclosure as a way of getting competitive benefit.

A third area relative to performance that I would pay attention to is how much money is managed by the same manager in the same basic style? That's not easy information to get currently. You can probably get it but you have to hunt around to put all that together. Moving from performance to investment approach. Investment approach involves more subjective judgments but it's something that I would want to know as much about as possible in choosing a fund manager. Ideally I'd want to hear in the manager's own voice what their investment style is. When I was at Solomon and chose a fund – I had to choose a fund for my 401-K I was able without reading the prospectus simply to pick the fund manager – the fund who was managed by the manager who had – whose approach to investment was the most rational in my view, that was because I knew who the managers were and talked to them. Investors aren't normally going to have that. But if investors have seen a disclosure in the manager's own voice of their approach to investment that is the best way to get a fix on the investment style and the investment approach. Plain English is a very important initiative of the Commission because it contributes to the availability of investors to understand investment approach as the manager would explain it. But there's a hazard involved in plain English and it's not the hazard that lawyer's usually talk about, it's not the liability hazard. It's the hazard that plain English will mask muddled thinking. If the investment manager has an unclear view about the way they're going to approach hedging or an unclear view about duration management in a bond fund I would much rather that come through in the description than to be hidden by a good copywriter's interpretation as put down on paper. Here I think the Board can play an important role in understanding what the manager's approach to investing is and in ensuring that that approach as set down on paper in plain English is accurate.

Mr. Baris:  Good morning, Chairman Levitt. Good morning, colleagues. I'm going to spend a few minutes talking about an issue that's on the minds of mutual fund directors, simply will the new push for plain English create more liability for funds and fund directors? The answer I believe depends on whom you ask. Let's look at plain English for a moment. What is plain English? It means writing clearly so that ordinary people can understand difficult concepts. It doesn't mean dumbing down, making short, leaving out important information. It also means re-tooling America's lawyers so they can write understandable prospectuses. This is a big task. Why should directors be concerned about plain English? Well, the old kitchen sink approach offered some measure of comfort throw in everything but the kitchen sink and there is some protection against the law but at least that's the belief. The new disclosure rules require funds to disclose principle investment strategies, principle risks of investing. The funds must summarize these ideas in an easy to understand way. But how can you easily summarize certain concepts like partially protected commodity-linked notes? The big fear, of course, is will something get lost in the translation? This all leads, I believe, to conflict, real or perceived, between the need to disclose enough information and the risk of creating more liability for funds and their directors. Recent litigation shows that plaintiffs aren't bashful about claiming that prospectuses omitted important information and nobody really knows what's going to happen in the courts. There aren't any cases we're aware of that address the liability issues in the context of plain English. Some say that plain English does not result in more liability for funds and their directors. The SEC has argued that plain English does not meet omitting important information and, therefore, no additional safe harbor is appropriate or necessary.

Now that you have the statement of additional information, which is the new garbage dump for detailed information, this is all incorporated by reference. There is some measure of protection there. Of course, you have provisions in the Federal Security laws that say if you in good faith rely on the regulations you should have some protection. But there are others that are concerned about increasing liability. What is a principle investment risk or strategy in the eyes of – is in the eyes of the beholder and it's often with the benefit of hindsight. The courts and plaintiffs' lawyers, of course, are not bound by the opinions of the Commission and its adopting releases. Again, there aren't any known cases that come under plain English. There's a flip side here, too. Will funds and their directors be liable for failing to write in plain English? Will this give rise to the creation of the grammar police? Will we see prosecution for new offenses such as statutory verbosity, intentional infliction of pecuniary distress, felonious use of a double negative with intent to confuse, and most heinous, the involuntary run-on sentence? Seriously, this gives rise to some questions. The questions of the day are what can directors do to reduce their liability? What can and what should the Commission do? Is it necessary or appropriate at this time to consider other avenues such as litigation reform?

Mr. Barbash:  Thanks to all of you. The statements raise a number of interesting themes. I want to come back and start to look a little bit more closely at some of them. My first question I wanted to direct to Norm and to Mickey. Your organization is – or the organizations with which you are affiliated have made re-tooling prospectuses a high priority. With the power of 20/20 hindsight at this point a year or two years after are you still convinced that it was an initiative that should have been priority? Have the results been favorable enough to support what you did?

Mr. Smith:  I think it's probably difficult to answer that question or measure the success of simplified prospectuses from an industry-wide – mutual fund industry- wide but as far as John Hancock goes we received considerably good press from it. Good comments from the shareholders and brokers. Good comments from peers in the industry. Good comments from the focus groups, where they took the Hancock simplified prospectus and compared it against competitors' prospectuses that had not gone through the revision procedures. So I think from, as a whole I would say that it was well worth our effort within John Hancock to do this. I think ultimately it will prove very beneficial to our shareholders as an education tool, as a guidance tool, as a training tool. These sorts of things I think is incumbent upon the leadership in the mutual fund industry to grab a hold of and make it all work. So, yes, Barry. Long-winded but, yes, it was well worth the effort.

Mr. Roth:  We would certainly feel the same way. We are a no load fund group. We market directly so we don't have brokers as intermediaries. We felt from the beginning that this was a very important step to take in communicating more clearly and more effectively with our shareholders and we think that we've done that. We feel very good about this. Our focus groups were quite enthusiastic about it, as I mentioned in my opening comments. We have actually received comments back from shareholders that they enjoy this and that's never happened before. As far as a question of how this plays in the industry, would it give us an advantage? I don't think so. I think that this is going to be very quickly a level playing field because I think there are just obvious and compelling arguments and reasons to go to this kind of communication of the basics of mutual fund investing with your shareholders that it will become universal.

Mr. Barbash:  When Bob was giving his statement he suggested at one point that there's an awful lot of information out there about mutual funds. You can get on a web site, you can go to most major financial publications, you can go to newspapers. There's a lot of information about it. Why do we need the prospectus if we have all that kind of information out there? From your perspective you've made – your organizations have made an attempt to make the prospectus worthwhile but why? What does it do for you relative to those other sources of information?

Mr. Roth:  I'll take a first shot at that. The prospectus is the user's manual and it is unceasingly important to try to get across to shareholders exactly what it is that they're buying, to have them understand the true nature of the investment, hopefully the relationship between risk and reward. Some of the comments Bob was talking about are very, very interesting ideas. Difficult to get across but extremely valuable. The head of our sales and service organization talks at times about not infrequent conversations that our reps will have with people who will call up and say, "I want some of the 40 percent fund." They don't know the name. They don't know what it's like. They don't know how it's composed. They just know that they saw in the newspaper or magazine that one of the funds was up 40 percent and that's what they want and that's, frankly, dangerous.

Mr.Baris:  I would just add to that the amount of available information, of course, is uneven and it's a sad reality but people are buying shares on the basis of information that may be good or may not be complete. But, more importantly, no matter how the investor is buying the shares it's the fund and the directors and the officers that are liable for what's contained in the prospectus which, of course, is required by law. So even though somebody is buying off an ad they can still find or allege a deficiency in the statement of additional information concerning something say, oh, I don't know, involving derivatives and plead a case and have a day in court.

Mr. Barbash:  Norman, in your discussion you talked about the issue of cost. You thought that it was significant to improving of the John Hancock Fund prospectuses that the funds incurred some of the cost of going forward. There's a lot of talk these days about mutual fund expenses and mutual fund expenses going up. How do you square paying out more money? Do you think it would be a worthwhile exercise for fund directors to look at the cost of improving prospectuses? Should a Board say, "Look, it's just too expensive? We're going to leave it as it is? We're going to – we'll comply with SEC rules but at the minimum it just costs too much?"

Mr. Smith:  Well, Barry, there's probably somebody in this room that could answer that question better than I can. Chairman Levitt can answer that question. He's the one that's been really talking of this and I applaud him for that. So, yes, the cost benefits are worth it. We've found that it wasn't as difficult to review these prospectuses. You save time and money on the legal review of them. The old hackney term "Economy of scale," we did receive that. It didn't take so many cover sheets in our organization to send out – to cover all the prospectuses that talked to the various funds by type. Again, as I mentioned before, this education tool to our users, to our shareholders. I can't emphasize that enough. Mutual funds play such an unbelievable part in the American economy today in the savings and our families that it's important that the average shareholder can sit down and pick up a piece of paper and – and with illustrations, with examples, understand what they're getting into with their savings. I think that's a very laudable act for all the mutual fund industry to get involved in.

Mr. Barbash:  What about the issue of director involvement in prospectus rewriting? I've talked to people in the industry who say we've worked hard to try to integrate our directors in the process of revising disclosure documents. But it doesn't work very well. I'd ask Norm and I would ask Don, as independent directors, what do you view the role as the director in the disclosure process. Obviously I would think neither of you think it's simply to sign off on the registration statement. But what is it? What is your role?

Mr. Dick:  I would put that in the context of how I view the overall director's role. The first instance, I think it's overseeing an orderly process that governs the relationship between the fund and the shareholders. And I think what happens in that overall process is that a good board can bring a substantial amount of business judgment to seeing that process works on an effective, high quality basis to deliver the product. The product to me is basically in its – at its root, an investment product. That sort of core has grown to be an investment product with a very high service element around it, and has further, is further rapidly evolving to be an investment product with a high service element with a very high cost component around it. And all of those things, I think, require and demand – both on the management and the directors – a high level of independent judgment. It seems to me that communications in general are an important topic within that mix. But when one gets down to the prospectus, which is what I understood you asked, Barry, it seems me that that is basically a tool that's a combination of a regulatory tool to make sure that certain specific bases are touched on the one hand, and a marketing tool which allows the firm as part of a total marketing mix to put forth its particular product. Therefore in that instance it seems to me that that particular role is in the primary instance a role between the sponsor and the regulators. And that while there is certainly an oversight role, it's within the context of what I view the larger mission as being. And I guess, to summarize it succinctly, I think we will more effectively have accomplished what we're all about if we do a thoughtful job of understanding and dividing the benefits of economies of scale than we will opining on a prospectus.

Mr. Barbash:  Don, you've won the prize for piquing the interest of the Chairman. I think he had a question for you.

Mr. Dick:  Uh-oh.

Chairman Levitt:  It's not a question, it's an observation, perhaps. And, first let me say, in general I think you're right on. You're instincts are good and sound. I think your company has been a pioneer. And it's that spirit that I would like to see. I would like to see restless, passionate directors. Directors who cared so much about the well being of investors that they ask the tough questions that many times corporate management find difficulty with. If we could harness some of the skills and creativity that go into marketing the funds in terms of how we can get across basic information to the vast majority of the public that simply don't understand what they're buying, what the risk may be, what the attitude of management may be, if you could in some way or other communicate to the investing public that Manager Smith, who has been sold in ads and direct mail for four years, has left. And now Manager Jones has come on board. And how do their investment objectives change. And I would like you to ask the question whether it's relevant to more frequently outline portfolio changes, changes in strategy. Sure, I'm mindful of the risks of liability and litigation, very mindful of them, having been personally sued any number of times. But with the amount of money from unsophisticated investors never having seen a down market out there, I think the need for greater disclosure, clearer disclosure, more controversial disclosure is just greater than ever.

Mr. Barbash:  Don, let me ask you a follow-up question. In terms of the role of the independent director, you've been a mutual fund director for close to 20 years. What's the biggest difference that you see in the role of the director, say, from the 1980s to the 1990s?

Mr. Dick:  In my view, Barry, that's a direct outgrowth of what's happened to the industry as a whole. The industry as a whole, it's rather obvious it was sort of at the margin of the investors' thought process at the point that I first came on aboard. Today, it is truly, I think unquestionably, certainly a corner stone product. That has obvious implications for all the things that these panels are discussing. Certainly, it affects the scope of each of the things that we were originally charged with doing in the 40s Act. Some of the things that I would mention here which maybe are not so obvious on a day-to-day basis, but pretty clearly come into my view of things, and that is that an independent director needs to have a very broad sense today of what's going on overall in the investment climate, what changes, what trends, et cetera are happening out there. Because really while one sits on a fund board – a legal entity – in most instances we sit reviewing a family of funds, and we need to put that in the context. So that's certainly one major change that I've seen – participation in maybe one or two kind of corporate activities, to participation in a fund. I think the next implication of that to me is that sort of matters of policy and strategic substance become playing a larger role than those of sort of procedural activities which pretty much dominated life 20 years. Another, I think major change is that we now are responsible for contracts – not only investment management – but contracts in the service area that as an industry must be generating billions and billions of dollars of revenue for the sponsors. That clearly is a different change from what existed 20 years ago. I could go on, but I think there are a few things that in my mind are pretty dramatic shifts.

Mr. Barbash:  It strikes me that a premise of trying to get good disclosure about a fund is that those who oversee the process have to have an understanding of what the fund does. That's a fundamental step. If you're going to make sure that you have a document that describes what the fund is, people have to understand. Does that – and some of the things that you were talking about, Don – does that imply that we ought to think collectively of having standards for independent directors? In other words, should independent directors have to have some kind of background in the financial world?

Mr. Dick:  I guess, my view comes back to what I said a little earlier. I think the overall role is really one of oversight of an effective process of bringing the investor to an investment product on which they're relying. Therefore, I think in that context the most important attribute a director needs to have is the ability to make the kind of business policy judgments that can assure that that process is as effective and efficient as it can possibly be. In that context, I think the board itself, therefore, ought to have a blend of backgrounds and skills and experience that can contribute – that can create a mix that contributes to that overall desired result.

Mr. Barbash:  So your answer would be not individually, but it would be a good idea of the board as a whole had some kind of –

Mr. Dick:  Better feel.

Mr. Barbash:  Norm, do you have a view on that?

Mr. Smith:  Obviously, my career didn't establish my position as an independent director anywhere. I believe that a successful person in a tough career can bring honor and integrity into that particular position. I believe the director ought to have a sensitivity for those for whom he is representing, and that's the individual shareholders. I try to stick pretty much myself on the John Hancock Board to the blue-collar shareholder. And I guess that comes from 36 years of leading Marines into harms way on occasion. You look out after the people that you're getting paid pretty dog gone good money to look out for. And I feel it's important that we do that in that particular manner and never lose sight of that. This is why I made my opening my comments – I sat in the back of the room yesterday and listened to this unbelievable dialogue that was the underpinning and the foundation of our industry and I got to thinking what would the Joe blue-collar come in here and think about in this particular case. And he'd have a tough time wading through it. And that's why I also think that USAA and Hancock's piece of paper that simplifies, educates, lay out, builds the credibility of the organization has something to do positively. And I can't sit on our board and make great financial disclosures and all this sort of thing because I haven't got that background. I'm learning. I work at it. I try. But somebody has to keep an eye on the great masses out there that are investing in our very lucrative business.

Mr. Barbash:  I'd say amen to that.

Mr. Dick:  Okay.

(Laughter.)

Mr. Barbash:  Jay, do you have a comment? Bob, let me stay with you. You suggest that a next frontier in mutual fund disclosure is tax-adjusted return information. And I think many would agree. In one of today's papers there is a story about the mutual fund business which suggests that one of the issues that the fund business has to tackle is just that, that an inability to deal with that issue is going to cause the fund business to lose some its luster. There's also a major-league sized ad in the paper today by one of the largest fund groups about a new tax efficient type of fund. So it seems as if it is an issue that a lot of people are focusing on. And I can tell just from my own experience as Division director was an issue that we focused on. But what would you view the role of the independent director to be in connection with that kind of an issue?

Mr. Denham:  I think it would be a very good thing if directors would insist on tax-adjusted disclosure performance for funds where that's relevant. Unfortunately we've have 59 years of experience under the Investment Company Act, and for the most part that hasn't happened yet. So I think this is an appropriate area for the SEC to require tax-adjusted performance results to be disclosed.

Mr. Barbash:  Mickey, any thoughts about tax- adjusted performance as a next frontier? Or any other areas where you think disclosure might be necessary or appropriate?

Mr. Roth:  Tax-adjusted performance is a very interesting topic, one that we've been very interested in for a long time. We have one of the oldest tax efficient – if I can use that phrase – funds out there – USAA Growth and Tax Strategy Fund. It's an interesting fund. It's approximately 50 percent common stocks, 50 percent tax-exempt bonds. In order to pass along the tax-exempt interest the tax-exempt bonds must constitute more than 50 percent of the fund. It has given us some interesting insight into this question. It is ranked by mutual fund rankers with balanced funds. But obviously it's quite different. By necessity its percentage in common stocks is lower than your typical balanced fund. And in the past few years especially that has been a great detriment to it. And then obviously it's bond portfolio is producing tax-exempt interest and the raw yield is lower than any other balanced funds bond portfolio yield. That's strike two. The performance figures are never adjusted by anyone who presents performance and so – and therefore the fund usually lingers around, interestingly the mid point of these funds and has never been in those comparisons a stellar performer. Years ago I remember our marketing people came and said to me, we can't sell this thing. And yet for as long as we've had it, month after month there are net sales of this fund. And it points out all parts of it. There is a hunger for this. There is a realization out there that there is something strange about the tax treatment that mutual funds must give to the actions which they take. But yet it is nowhere near being highlighted in the typical measures of funds. Maybe the ultimate comment on this is I spoke about this with a reporter about a year ago. And we have tried to promote this idea of tax-efficient investing and the after- tax return. And his comment to me was, who cares? That's his view from his readers. So there is an opportunity out there and, frankly, I intend to have our company keep hammering away at it. That particular fund has a very nice, long-term tax record. And if we ever do – which we do once in a while – find a publishing of tax-adjusted returns it leaps way up. But it's a complex topic and one that is difficult for the average investor to grasp.

Mr. Barbash:  Mickey, one quick follow-up question and then I want to turn to the infamous L-word. What about the argument that tax-adjusted returns is not all that important to many in the mutual fund business who invest their tax-exempt vehicles? Is that enough of a reason not to make it a priority?

Mr. Roth:  I think Bob touched on that very interestingly when he said that it would be easy enough to go through the range of possible tax situations. And obviously one of them is zero. When we look at the USAA Income Fund, goodness, I think that about 80 percent of our accounts in that fund are in IRAs or other tax-sheltered vehicles. And, obviously, if we were to produce a tax-adjusted statement for it, the income fund would be greatly affected. So I think it forms part of a viable spectrum.

Mr. Barbash:  Let's finish out the time by talking about liability. Jay, you raised that in your discussion. Do you find that independent directors regularly ask you the question, if I do this – or if I take that action, will I be sued? Do you find that it's first and foremost on directors' minds?

Mr. Baris:  Yes.

Mr. Barbash:  What about the directors? Do you – both of you intimated in what you were talking that it is an issue?

Mr. Dick:  I mean, it's obviously an issue that should be dealt with in the context of where one heads. I think at the end of the day there needs to be enough appropriate disclosure that the investor can make a very informed judgment about where are the – particularly where are the material risks in this particular activity. I think that's the one that most concerns me out of the mix of possible areas of litigation.

Mr. Baris:  We get asked routinely at board meetings – we're put on the spot – will this – is this okay? And they're asking the lawyers to make a legal judgment, which, of course, is appropriate. But what it really comes down to – and sometimes the appropriate answer is – are the directors asking the right questions? Are they overseeing in an appropriate way to ensure that the process is in place so that their business judgment is being exercised?

Mr. Barbash:  Picking up, Jay, on some remarks in your statement, do you think that the SEC is supportive enough of liability concerns? Does the Commission pay enough attention to liability concerns?

Mr. Baris:  Well, I think that the Commission is obviously concerned about it. As Chairman Levitt mentioned earlier, he's very well aware of the liability concerns. But reasonable people can differ as to how far and how active the Commission could be in reducing liability. And I don't think there's an easy answer, but I do think there are other things that the Commission could consider. The Commission considered and rejected a separate safe harbor for liability under the plain English rules. And I think that's something that remains to be seen. And it's something I think the Commission should reconsider.

Mr. Barbash:  Bob, do you have any views on liability safe harbors?

Mr. Denham:  I don't see a compelling argument for liability safe – I guess, I don't see a compelling argument for liability safe harbors in connection with plain English disclosure. I think plain English if it's done well, helps a firm avoid liability. Because if it's done well, it forces you not only to a plain explanation of what you're doing but to thinking out in a clear way what it is you're doing. And I think that the liability issues often come out of – you know, the case has to be expressed as a disclosure case. But underlying the disclosure case, there's usually a real muddle about what how the funds' management thinks about the way its investing. And that's the muddle that needs to be exposed as you do in plain English prospectus.

Mr. Barbash:  I was going to ask a question which I think you just gave the answer to, what in your judgment – and I would ask this to Jay, as well – what in your judgment provides the greatest protection against liability? It sounds, Bob, as if your answer is if you're clear about what you're investing in and there's clear communication from the fund managers to the lawyers to the directors, you will get a product that will describe it well and you'll minimize liability that way. Is that fair?

Mr. Denham:  Absolutely, investors have a lot of choices to make among mutual funds. And one of the best roles directors can play is to help assure that the description of the choice that is offered by a particular fund is an accurate description so that the investor can make a reasonable choice.

Mr. Barbash:  Jay?

Mr. Baris:  Yeah, and I agree completely with what –

Commissioner Unger:  Excuse me. When you're talking about liability – and I apologize if you already specifically laid out what areas of liability you're concerned about, but what exactly are you most concerned about in the area of liability?

Mr. Barbash:  Generally, here the focus has been on prospectus liability. So we're talking about the role of lawyers, management and others in drafting a document that might be shorter, in plain English. And it may or may not be shorter. But the question is whether there's greater liability potential coming out of disclosure principally, although the question is really posed beyond – beyond disclosure.

Mr. Baris:  Just to follow up, I agree with what Bob said. And I think that what is critical is getting the portfolio managers involved in the process to make sure that what they're doing is accurately disclosed in an easy to understand way. And that's something that the directors can ask management: are the portfolio managers involved, and to what extent? And carrying that one step further, the record should reflect, the minutes of the meetings should reflect that these questions have been asked. And I think that would go a long way to reducing liability.

Mr. Barbash:  Let me conclude by asking each one of the panelists a question. I know this is going to take the panel over our allotted time, but, you know what, it's not the first. And it's not the last time with me.

(Laughter.)

Mr. Smith:  Well, I guess it would be to participate in any litigation at the earliest possible stages when a fund's use of plain language is being contested. And if you dig into my statement, you'll find that's the last thing at the bottom of the page 2. Thanks.

Mr. Barbash:  Mickey?

Mr. Roth:  It's an interesting question to try to answer what would I want the SEC to do for us. The key thing here I think – in my opening statement I talked about the great trust that has grown up, that has propelled the mutual fund industry to become the premier financial intermediary for the American people. And I think what the Commission can do, number one, priority is to do things to preserve that trust, to make sure that it continues to impel us toward things that work toward the benefit of the investors, to foster their understanding, and a great example is this plain English initiative.

Mr. Dick:  If I understand I think the Commission's thrust in the last couple of years it is to challenge directors to be more actively involved in what I would term are matters of substance, matters of policy, matters of strategy. And I think that is very positive. I think what I ought to ask the SEC in that context would be to work with the industry to look at the overwhelming stack of paper that we get which I would call matters of procedure to see if there isn't a substantial amount of that – or at least some of it – that could be handled in some other way, and therefore free the total activity to be more strategic and substance-based.

Mr. Denham:  I would encourage the Commission to look for opportunities to highlight best practice. It's the very important job of the Enforcement Division to highlight worst practice. And that necessarily has to be part of what investment management does. But the Commission should look for opportunities, and I think that's the spirit in which this conference is being done, frankly, to highlight best practice among firms and to be able to point to ways in which funds are providing more disclosure than is required, clearer disclosure than is required, more accessible through the use of very well designed Web sites, for example, more accessible disclosure than is required. And I think that's maybe the best service the Commission could render.

Mr. Baris:  I would say there are two things. Number one, keep doing what you're doing. I think that the plain English initiative is very successful and will have long-term benefits that will be very, very good. And the second thing is – which you will find on the bottom of page 5 of my presentation – is stand up for the directors. If there is a lawsuit in this area, I would urge the Commission to consider filing a friend of the court brief, too.

Chairman Levitt:  On behalf of the Commission, I would say that these recommendations are all really sound ones that we would embrace. And I think that all of you are a great example of the kinds of people who should be squiring the boards of investment companies and we're very lucky to have you make this commitment, thank you.

Mr. Barbash:  I would note that we have a bunch of questions which we didn't get to. And feel free to ask anybody on the panel about the answers – come up afterwards. I would note that Jay's and my rates are a lot higher than Paul Roye's at this point. So you may want to pose the questions to him. Thank you very much.

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Role of Directors in Acquisitions of Investment Advisers and Reorganization of Funds 

Mr. Roye:  Our next panel is on the role of directors in connection with acquisitions of advisers, changes in control situations, and reorganizations of funds. As I'm sure you know, there has been a fair amount of consolidation in the mutual fund industry and in the financial services industry, generally. In the division, in the last year, we probably saw an exemptive application once every couple of weeks, raising merger, change, of control issues, and we're trying to do something about that by amending our rules to eliminate the requirement for some of this exemptive relief. But it's a trend that's here. It will continue. It raises unique and special issues for independent directors.

I think we're privileged today to have another distinguished panel to discuss this very important topic. To my immediate left is Rachel Robbins. She's the general counsel and managing director of JP Morgan and Company, Inc. and of JP Morgan Securities, the US securities subsidiary of JP Morgan and Company, Incorporated. She heads up the legal department and serves as chairman of the board of the American Bankers Association Securities Committee and is a member of the SIA Federal Regulation Committee. Next to Rachel is Dr. Joseph Hankin. Joe is the president of Westchester Community College and a full professor at Teachers' College, Columbia University. He holds Doctor of Education degrees in both history and administration of higher education from Columbia University. He serves as president of the Middle States Associations of Colleges and Schools, and is an independent director of the Stagecoach Funds and the First Choice Funds. Next to Joe is Dawn-Marie Driscoll. She is an executive fellow on an advisory board at the Center of Business Ethics at Bentley College. She is president of Driscoll Associates, a consulting firm. She was formerly vice president of corporate affairs and general counsel of the Filene's Department Store chain, formerly a partner at the Boston law firm of Palmer and Dodge. She is an independent director of several Scudder Kemper mutual funds, a member of the Board of Governors of the Investment Company Institute, and chairs its Directors Committee. She has also published several books and articles in the area of business ethics and is generally regarded as an expert in that area. Next to Dawn-Marie is Dave Butowsky, who is one of the deans of the '40 Act Bar. He is the main partner in the New York law firm of Gordon Altman and Butowsky. Prior to entering private practice, Dave was on the staff of the SEC and was the chief enforcement attorney in the predecessor to the Division of Investment Management, responsible for the SEC's nationwide inspection program for investment companies and advisers and responsible for the Commission's enforcement effort.

What we would like to do this morning is start off with Dave, to sort of lay out the legal framework for us that director's operate in when they consider changes in control type situations, and then we'll turn over the discussion to Dawn- Marie and Joe, both of whom have been through several changes in control in connection with their mutual fund director responsibilities. Then we'll go to Rachel, who will give us a perspective of the acquiring firm in those kinds of situations, and touch on some of the issues raised by the global aspect of consolidation in the industry. Dave.

Mr. Butowsky:  Thank you very much, and good morning to everybody. I've been asked to, as you just heard, set out the legal framework of independent director responsibilities in connection with acquisitions and reorganizations. I've been asked to do that in 10 minutes, but Barry Barbash has told me I can have an additional 10 minutes.

(Laughter.)

In order for the safe harbor to work, the provision requires, first of all, that for three years the board must consist of 75 percent independent directors, almost double the amount required by the statute; and second of all, that no unreasonable burden be imposed as a result of the transaction. There is a definition of "unreasonable burden" in the section, but you can understand it if I tell you that what it is intended to do is to protect against the possibility that the new adviser would use the new fund's assets to recover the purchase price. Now, what acquisitions are we talking about? We have banks, sometimes already controlling their own mutual fund complex, acquiring yet another one. We have mergers among equals of broker dealer organizations, each of which already have mutual fund complexes of their own. In each instance, we have a flight to asset growth and profitability. The transactions can be large and larger, and the prices steadily go out of sight. I remember years ago, and every year when I remember how long ago it's been that I left the Commission, I realize that $10,000 per million of fund shares under management is really not a heck of a lot of money. Prices of 4 percent, now, of assets under management are not uncommon.

Whatever the transaction, there was almost always, at closing, the automatic termination of the advisory contract as a matter of law. Other contracts frequently have such provisions, even though not required. For example, if there are affiliated transfer agents or affiliated custodians, those voluntarily frequently insert the automatic termination provision, and agreements pursuant to a fund's 12(b)(1) plan are required to terminate automatically. In the role of independent directors representing the interests of shareholders and I'm addressing most of this to the independent directors in the room we'll be responsible for determining, in effect, whether the transaction goes forward. In that regard, you will have to exercise due diligence. In going through that process, you should avoid minefields and be advised every step of the way by independent counsel. I don't necessarily say that to get business for myself. I say that because there are few independent directors who know how to handle these kind of transactions, and you should be advised by somebody who knows what is involved and can advise you, and who is completely independent of any affiliation with management. He or she should be providing you with memos covering every step you take, including the details of your due diligence: What do I have to get? When do I have to get it by? And what should I do with it once I get it?

Remember that the funds, on whose boards you sit, were sold to shareholders with certain representations, investment policies, and limitations. They have a performance record, costs, including advisory fees, and everything that makes up the ethos of a fund organization. Representing the interests of those shareholders, you must decide whether or not to support the proposed deal. For example, who is this new investment adviser? Who are its affiliated and control entities? What is its financial and compliance background? Is it capable of providing continuing quality investment advisory and other services? What has been the performance of its fund and non- fund clients? Are there any of the statutory bars mentioned in Section 9 of the Investment Company Act, or does the acquirer's structure make that a potential problem? Anybody who has questions about that, please see me afterward. Does the new adviser have other funds? Are they similar to yours? How will any conflicts be resolved? What has been the sales and performance records of their funds, and how are they marketed? Are there affiliated transfer agents and custodians? If not, who are their transfer agents, custodians, attorneys, accountants, and any other support persons? Will the new adviser acquire the old adviser? Will the compensations of personnel match or will you have a flight to quality or compensation later?

These are just some examples of what your due diligence includes, but that's only part of the exercise. The independent directors must be prepared to approve or not approve the new advisory contract and determine whether to recommend the transaction to shareholders. In that connection, there will be a proxy statement, and there is case law requiring that the basis for your decision to proceed must be stated in detail in the proxy. Depending upon the timing, you may also have to determine whether to continue the contract with the original adviser, since the acquisition deal may not close or may be delayed past the time when the original contract terminates by lapse of time. For those of you not familiar with them, I've described what we call 15(c) - procedures that are necessary for you to follow. You will find them on Pages 2 through 15 of my materials. Ordinarily, these transactions will also involve regulatory considerations. For example, if there is a bank in the picture, various of the many banking statutes, rules, regulations and letters may impact upon the permissible aggregate holdings, for example, in the complex, post- transaction. That may or may not be a deal stopper, but you certainly should know about it. Was the affiliated broker of the acquirer a repo party for your funds, or were there other principal transactions that your funds did with that broker? You will probably need relief from 17(a) of the Investment Company Act if that's the case.

I have mentioned these regulatory concerns just on the Investment Company Act side, and one on the banking side, but you'll find them in my materials, beginning on Page 16. A word about reorganizations very quickly, since time is fleeting. Acquisition transactions likely will involve, usually sometime well after the closing, possible reorganizations. Usually, these will be mergers of some of your funds into some of their funds, or both funds into a merged fund. Open-ended or close-ended are also possible, as are numerous other potential reorganization transactions. The directors of the acquirer have some concerns. These include such things as whether unaccounted for liabilities are being assumed, tax issues, dilution, new directors, and personnel of their investment adviser. But it is the independent directors of what I call the decedent funds who bear the biggest burdens. I've set out some of the most important considerations for them at Pages 19 to 24 of my materials, and we may get into some of them as we go along. Thank you.

Mr. Roye:  Dave, before we on to the independent directors, you mentioned the importance of the due diligence process. How would a board approach that, and how would you, in counseling the board, really approach that process? Would you be initiating questions to the acquiring firm, or other approaches? Could you maybe briefly touch on that?

Mr. Butowsky:  I would first prepare a list, if I'm representing the independent directors, obviously, of the materials that should be supplied. I would then have a meeting with the directors and tell them what we have asked for and why, and explain to them what their responsibilities are. Once we've received the materials, we would examine them to determine whether there's anything else that we need or there were any important legal issues that have to be resolved. We would then have a meeting with the independent directors, tell them what our findings have been, and be prepared – tell them the questions that they ought to be asking, and respond to those questions.

Mr. Roye:  Have you seen situations where there is a need to go beyond counsel and bring in outside experts, accounting firms –

Mr. Butowsky:  First of all, we always, my clients always use outside experts. They use their private accounting – their independent accountants, for example, to measure profitability. They use a service which specializes in putting together statistical information that is required by such cases as Gartenberg and its progeny for presentation, and also, this provides us with people in the event that there is a lawsuit to explain, sometimes better than the independent directors can, exactly what they did and why they did it.

Mr. Roye:  Dawn-Marie?

Ms. Driscoll:  Thank you. And thank you, Dave. That was a very good summary. It brought back lots of memories. I'm going to start with a little philosophical preamble to my remarks about the process and what directors actually do. In my view, the most important thing that this industry offers shareholders may surprise you. It's not performance. It's not low fees. It's not professional management. It's not outstanding 21st century service. In my view, the most important thing that this industry offers shareholders is its integrity. This is a thing we've heard before. But we are talking about $5 trillion of uninsured money. Directors think all the time about the fact that their shareholders send money off in the mailbox to a fund that can't exactly kick their growth and income fund, and they have a great deal of trust. Therefore, in my view, that's the most important responsibility of directors, and particularly independent directors, is to oversee the trust of this industry. I don't happen to think we should second guess shareholder decisions, particularly their investment decisions. We make it clear what it is they're buying, what the risk parameters are, what the total costs are. They can make that decision. What they have a harder time, I think, understanding, is the integrity of what they're buying.

You heard a lot on the other panels about the day- to-day activities of independent directors, and I think you now have a picture that over the years we have a good sense, from our adviser, what their values are, what their policies are, whether it's brokerage, evaluations, or shareholder servicing. When an acquisition comes along, this is D-day for independent directors. You may be talking about a whole new ball game, a whole new team. And I think this is probably one of their most solemn and serious responsibilities, is to do their due diligence with regard to an acquisition. So what I want to do is not repeat some of what Dave has said about the legal responsibilities, which I think are pretty clear, but to kind of give you a word picture of what it is we do when we are presented with an acquisition. So picture, if you will, a boardroom with directors of the caliber of a John Hill, a Bruce MacLaury, a Manuel Johnson, a Don Dick, a Norman Smith. And parenthetically, I think I should say, you know, we've seen complaints about directors sitting on multiple funds. I ask you as a shareholder, which would you rather have doing the due diligence about an important issue with regard to your fund, a group like the individuals I just described, sitting in a boardroom with their adviser, or 500 directors, all of whom each sit on one fund in an auditorium like this. The process is not going to work, in an auditorium kind of boardroom. I've emphasized the word "Work." I think when you have an issue of an acquisition, directors have a lot of work to do.

My handout was 22 questions that independent directors might ask, and you will be glad to know I'm not going to go through all 22 and answer them. I do want to highlight a couple, to sort of give you an idea of what we do. One of them is: What is the timing of the acquisition? Directors cannot be rushed in doing their homework on an acquisition. I should have gone back and counted them up, but my recollection is that when the Scudder trustees were looking at the Zurich transaction, we probably had 25 meetings that year. Now, not all of them were solely about the acquisition, but I can guarantee you that we discussed the acquisition at every meeting, and that doesn't include telephone conferences among the directors in between meetings. Number 7 parallels the question, should you hire outside consultants? I'm not a big believer in over-lawyering things, but I think if there is a time in which the adviser needs its own lawyers, the fund needs its own lawyers, and the independent counsel needs their own lawyers, this is one. I want to underscore the importance of outside auditors, not only looking at issues of profitability, but cost allocations and understanding the financial aspects of the transaction. I would include outside industry consultants. I think it was Don Dick who commented on the last panel about how important it is that directors take the time to understand what is happening in this fast-moving industry.

Again, this is the time that you might want some of these consultants involved with you in the process of analyzing this transaction. Number 14: What is the acquiring company's reputation for integrity, and what is the reputation of its senior executives? This is due diligence that sometimes doesn't come up on an SEC or a '40 Act checklist, but I think it's very important, and it's not something that you can find by reading a paragraph in the annual report or by looking at a line on a resume. This is something that also requires a lot of homework on the part of independent directors, so that they are satisfied that the values of the acquiring company will match the values that they have established over the years with their adviser. And I'm not just talking about legal compliance. I'm talking about things like frank and open communication, giving enough information, the respect that they treat independent directors, and not just a couple of independent directors, but all of them. Number 15: Obviously, who is going to oversee compliance and ethics? What are their standards? I've said that shareholders can read the materials that we put out, plain English or otherwise. They can talk to their brokers, they can talk to the telephone representatives, they can read the financial magazines, they can look at the cost tables. It's hard for shareholders, I think until it's too late, to get their arms around issues of integrity. Directors, like all of you, read in the paper about long-term Capital or Orange County or everything else, and they say, "Those are smart people." Do we have smart people at our fund, with our adviser? Do we have them on the compliance side? Do we have them on the information technology side? How can we track what our people are doing? And who is going to be in charge of the compliance and ethics standards of the acquiring company?

Number 16: Have there been similar mergers or acquisitions that have not worked, and why? Again, this goes back to understanding what is happening in the industry. I think you can learn from other transactions that have gone on before yours and find out what questions should they have asked that we haven't. Number 17: If we need new directors who should they be? Dave mentioned the 75 percent requirement. There's been the suggestion made that the acquiring company, particularly if it already manages funds, may want to suggest candidates to fill out the Board. It's just my personal opinion, I don't think that's a good idea. I'm a great believer in independent directors choosing other independent directors who the adviser does not know. I know that puts chills of fear in some advisers but I think that independence is one of the most important characteristics of an independent director. The more ways that you can ensure independence the better the process will be.

Question No. 20. What happens if we don't approve this? I think you have to answer that question and that involves understanding why this acquisition has been presented. Is the adviser simply cashing out or are they looking at access to capital as this industry and all its technological Y2K and salaries and everything else gets more expensive? It may be that if you don't approve this you have to figure out what your next move is going to be. And Number 22, the final question, what other questions should we be asking that we haven't? I think we should ask that of our lawyers, of our accountants, of our outside consultants, of other directors, other companies that have gone through this. I think this is a question that certainly I've heard independent directors ask at their director professional conferences with regard to their own Boards. How can we do this better? What things should we be doing that we're not? And certainly there's no more important time I think than in an acquisition to be asking that question. Joe?

Dr. Hankin:  All, thanks for the opportunity. I come to this panel as someone who's been a community college president for 32 years and who has been on one fund Board or another for a dozen. I began in 1987 as an independent director of FundSource sponsored by Furman Selz under the tutelage of Ed Agem and John Pollege. We quickly got involved in enterprises known as Continental Asset Management Funds and Olympus Funds where I came to know Jeff Steele, your former colleague with Dechert, Price and Rhoades. As Barry Barbash has pointed out, back in 1995 a Goldman Sachs study predicted an urge to merge. That within five years the investment management business would be characterized by 20 to 25 giant firms, each with at least $150 billion in assets under management. At one point the SEC's Division of Investment Management received merger-related applications at the rate of about one a week. He went on to tell us that The Wall Street Journal proclaimed in one headline, "It's a broker. It's a banker. It's a mutual fund group." Bigger, of course, is not always better. He also told us that one consequence of consolidation is that it may reduce the number of distribution channels available potentially making available funds more expensive to the investor who hardly knows how much her or his funds charge. In all this the role of the director, especially the independent director, becomes more important. You can't see it because there's no overhead projector, but there's an overlay here that shows a little minnow being gobbled up by a larger fish and in turn by two larger fish beyond that. In my experience the Olympus US Government Plus Fund became AMED, which in turn became a Fortus Fund.

A new group was then formed called the Pacifica Fund Trust, first with the San Diego Trust Company and then with the First Interstate Bank of California, becoming the sub-adviser, Dreyfus, the current distributor and administrator, and the Pacifica American Fund, the trust. Dreyfus was replaced by the Pacifica Funds as distributor and the whole enterprise was reorganized with a Denver-based West Corp. trust. Two independent trustees of the latter joined three of Pacifica. This entire enterprise was subsequently joined to the Wells Fargo Bank, Stagecoach, and Overland fund groups in 1996 and I was the surviving independent director to go on to the Stagecoach Board. This was done because the old Board insisted that there be at least one carry-over Board member. Now I had withdrawn from consideration and suggested one or two others whom I felt to be better suited but they selected me so here I am. This odyssey is not yet complete, believe it or not, for Wells and Norwest have now joined as most of you know. They're in the process of merging their funds. This enterprise has gone, therefore, from a $200 million fund group when I first became involved to a $27 billion group under Wells being merged with a $25 billion group of Norwest into a larger group of over $50 billion. Not only did the outgoing Pacifica Board insist on representation on the new Stagecoach Board but as independent directors we felt that some of the proposed fund mergers were inappropriate and insisted on re-working the organization of them into more compatible groups. So what were some of the other heightened due diligence functions and activities from the point of view of the independent directors? And if this sounds repetitive let me put on my educator's hat and say it's reinforcing rather than repetitive. (Laughter)

But I went through my notes and minutes of all of these actions and distilled out a number of things that I considered to be the most important things. To determine the benefits and risks as well as the cost of each transaction, to make certain that the transaction wouldn't result in a dilution of the interest of the fund's shareholders. To scrutinize the organization and personnel and the financial condition, the investment experience and performance, the marketing capabilities, the administrative and compliance review system, the fairness of the terms of the transaction. The acquiring fund's track record, the sales cost and expense ratios of the acquiring fund, and the availability in the acquiring fund of comparable shareholder services. Also to retain independent counsel, which is absolutely a prudent step, to oversee the advisory contracts with the funds. In the meantime, you might wonder how our role changed with regard to regular ongoing business during all of these activities. Frankly, we continued to do our jobs at protecting the shareholders to the best of our abilities. Among our responsibilities we continued to perform due diligence, approve minutes, check performance, assess market conditions including the Fed easing rates three times, engaged in compliance reviews, review 1787 transactions, and look at 10F3 transactions, approve dividends, oversee capital gains distributions, review the Codes of Ethics, appoint sub- advisers, accountants and, indeed, all service providers and replace them as necessary or where we felt that one or another would provide better service, and so on. In short, our role was to keep the ship steady during the voyage through so many shoals. A columnist recent wrote that, "The mutual fund industry is like cable TV, lots of choices but most of them are reruns." It was our objective as both interested and non-interested directors to make sure that the shareholders were properly represented throughout. Despite cases like Navellier and Yachtsman we did so.

We need the strong support of the Commission in reinforcing our roles as guardians. There's always a lot of talk in articles and the like about how independent can independent directors be? Witness the recent Wall Street Journal articles in the last month. I have found that in my experience my fellow directors have, indeed, furnished the independent check on the management of the company, have acted as fiduciaries, have been fully informed, have exercised their independent business judgment including the duties of loyalty and care. Where there were different compliance practices the directors had to choose which ones were best. We knew that we would be judged in accordance with the business judgment rule that court cases focus on a number of factors including advanced dissemination and review of written materials by the directors, consultation with management regarding material issues, consultation with financial and legal advisers retained by the Board, review of the documentation in question by counsel with the Board. Due deliberation at Board meetings, and not rushing. The willingness to act independently and raise questions concerning advice received and a demonstrated concern for the effects of the transaction on shareholders. If I've said that three times that's because it is our most important function.

In summary, fund Board and directors have a number of obligations, to satisfy themselves that transactions serve the interest of the fund, of course, but to examine the credentials and track record of the proposed investment adviser carefully. Does the acquirer currently manage mutual funds? How is their performance compared to others? What benefits are expected to accrue to fund shareholders as a result of the proposed acquisition? Will shareholders be disadvantaged? What additional service or fee reductions might be negotiated as a result of economy of scale? At the least directors should seek commitments that the fund's pre-merger fee structure and expense ratios will not increase. Although the funds themselves are not parties to the merger agreement, directors should understand the legal structure of the acquisition transaction as they might relate to employment agreements, retention incentives, fund, board and shareholder approval, and indemnification, to name a few. Will the acquired adviser's personnel be asked to relocate? Will that result in a loss of personnel and experience and performance? Will current portfolio managers be replaced? Will funds be managed differently? Will philosophies change? What are the styles and cultures of the two organizations like? Will oil and water mix? What are the financial conditions of the acquirer? If it is a subsidiary of a larger company, as has happened in a number of these instances, will sufficient capital be available to support the advisory business? Will any of the product line be eliminated? Will there be substantial changes in fund officers, directors, and counsel? What are the costs of the acquisition and who will bear them? What is the acquirer's compliance record? Will there be additional distribution channels and how has the distribution arm of the acquirer's organization performed in marketing and selling its products? In all of this the independent directors have an opportunity to show just how independent they are and how much they value the shareholders whose interest they protect. In my field I often hear other Presidents say that, "Good Board members ask great questions and accept bad answers." In mutual fund policy directorship there's no room for bad answers.

Mr. Roye:  Let me ask a question of the independent directors. In this age where we have, you know, the mega- mergers where, huge financial service firms with far-flung operations where the mutual fund piece of the operation is a significant component but in the scheme of things not significant. You have, you know, the CEOs of these firms, you know, looking at a variety of different factors and thinking when they get the Boards together the deal is done. Then somebody says, "We have to go to the mutual funds and get them to approve new advisory contracts." Are independent directors in the mutual fund framework involved in these mega-mergers really a factor?

Ms. Driscoll:  Well, I'll answer that first. I think we're a big factor because we have, essentially, veto power. You know, if they don't care about the funds being part of the acquisition then maybe they don't care very much whether we veto it or not. But, you know, my experience has been, and I suspect it's true with most acquisitions, is that they want the funds to come along. So they have to pay attention to directors. Now they might not like it that this little band of independents are asking them all kinds of questions but they have to satisfy us. You know, I agree with what Joe said, The best thing you can do is to just keep asking questions, taking your time. I mean this is the real moment in which you have a big stick and they do have to pay attention.

Dr. Hankin:  They may see us as a fifth wheel but contracts have to be re negotiated and they concur with –

Mr. Roye:  The other question I had related to – and I guess Joe, in your case, you've been through so many changes I guess you can't count them on two hands. But how do you keep the shareholders apprised of what's going on and informed in this process? I mean you'd think it's difficult enough for you as a Board member to stay on top of what's going on. How do you bring the shareholders into the process? I think one of the comments that came out of some of the earlier panels is that, you know, is there some disconnect between the funds and the shareholders? How do you relate to shareholders and get information to them, you know, when there are changes like this impending for their funds?

Dr. Hankin:  There is the potential of disconnect. The shareholders are interested in two things I think: stability and performance. If that is met and if there's regular communication which we have an obligation to do in a plain English format, by the way, that there, too. I believe that the shareholders seem – at least through all the actions that I've seen, have been reasonably happy.

Ms. Driscoll:  Can I answer that, too? One thing that in my experience directors spend a lot of time on is talking and questioning about what are we telling our shareholders and how and when? You know, we have called the 1 (800) number anonymously acting as a shareholder and asked them questions just to find out what the telephone reps were saying back. You know, we've reviewed letters that have gone out and when the final proxy comes out we have worked on the draft proxy, we've changed language in there; we've added language to make it clear, you know, why this is good, the things that we've considered and what we looked at. So I think there's a high degree of director involvement and I'd say that that's a continuing theme of questions at every meeting and through every meeting, "What have we heard from shareholders? What have we been saying to shareholders?" Then we go out and verify what shareholders are being told as answers to some of their questions.

Mr. Butowsky:  Well, I have one client whose here in the room today who goes out and has actual shareholder meetings at the locations throughout the United States which is the basis out there in places like Arizona, Kentucky, etceteras. He gets more than 100 people at each one of those meetings asking questions. I have other clients who on a regular basis report to the directors on what are the complaints that are coming in and how are they being handled? How long does it take to answer the telephone, etceteras? Pretty much akin to what Dawn-Marie was saying.

Ms. Driscoll:  We've actually gone out to a shareholder servicing center and sat with earphones on the phones for an hour or so listening to what the calls are coming in and what the telephone reps are telling people. So we're as involved as we can be but we're always looking for new ways to first-hand capture shareholder concerns.

Dr. Hankin:  I would think both of those practices are probably unusual.

Mr. Roye:  Let's turn to Rachel. Rachel, you can give us sort of a perspective from an acquiring firm as well as some insights as to the globalization of this acquisition process.

Ms. Robbins:  Thank you, Paul. I'm here because JP Morgan is a broker, a banker, and a mutual fund. We have over $40 billion in assets under management in the JP Morgan Funds. About half of them in the US and half of them situated in Luxembourg, the Bahamas, Spain, France, Canada, and we've recently announced a joint venture with DKB in Japan. You've heard a lot from the fellow panelists about questions from directors in acquisitions. I thought I might touch on the role of directors in an acquisition that didn't involve a change of control so there was actually no legal requirement for the directors to approve the acquisition. Then, as Paul said, I wanted to touch on some of the challenges in the global fund business. A year ago Morgan acquired a 45 percent economic interest in American Century. This was structured not to involve a change of control, primarily as a business matter so as not to interfere with the entrepreneurial spirit of American Century and not to disrupt their business momentum. Although we purchased a 45 percent economic interest our voting control was significantly below 25 percent. Therefore, we were able to conclude, both as a business matter as well as a legal matter, that there was not the change of control here. Nevertheless, we were very sensitive to the concerns of the independent directors of American Century.

American Century has two mutual fund Boards, both with a majority of independent directors. Our goal really was to keep them informed to make sure they understood the transaction and to make sure they were comfortable that the transaction would not interfere with the day-to-day operations of those funds and to make sure they had whatever information that they needed to satisfy themselves in this regard. In particular, since we are so heavily regulated as a bank holding company and in all spheres of the brokerage business, the securities business, not only here but globally there were a lot of issues. They received a detailed memorandum on analyzing each of the restrictions on our business and how they would apply or not apply to the business of American Century. They wanted to understand what procedural changes would be necessary to their business and they did need to adopt new procedures in the brokerage area and to satisfy 10F3 syndicate purchases in deals in which we were involved. They needed to, for Federal Reserve Banking law purposes, appoint new officers and appoint an independent distributor. We wanted to make sure that they fully understood the implications of those changes. The challenges raised by a global organization I think were really illustrated in this transaction. As I said, this ought to have been a relatively simple transaction because it didn't involve a change in control. Yet, the issues that we all had to understand, including the independent directors of the funds, were staggering in their complexity.

The issues that were raised, and I will not list all of them, but here's a partial list. We looked at issues under the Investment Company Act, obviously, the Investment Advisers Act, the Bank Holding Company Act, the Savings and Loan Holding Company Act, the Securities Exchange Act and Regulation M, the Public Utility Holding Company Act, state gaming laws, the Commodities Exchange Act, the New York Stock Exchange rules, State Anti-Takeover laws, state insurance laws, foreign securities laws, and the list goes on. Needless to say, the American Century Board needed to rely a lot on outside experts, and they were fortunate to have Mike Eisenberg advising them, one of the boards, but it was – it is a very complex process. The memorandum that we received from outside counsel analyzing all these was 26 pages, single spaced, summary. Now, as I said, this ought to have been a more simple transaction, because many of the tough legal issues, the aggregation issues that arise in most change of control acquisitions really were finessed by the fact that we did not have a change of control here.

The fact that the portfolio managers are totally independent of JP Morgan at American Century and are not compensated by or influenced by JP Morgan, the fact that we have strict information barriers, were able to address a lot of the legal issues. And we did not need to integrate our compliance departments, which obviously would have been another major issue, both from a systems point and from a number of other perspectives. Nevertheless, we do meet regularly with the compliance department of American Century to discuss common issues and share best practices. Having said all that, I think we would say that in our experience the US regulatory model does represent best practices which we are exporting in our global business. For example, we are working with clients in offshore funds, working toward a plain English approach in those offshore funds, transparent fee disclosures, codes of ethics, use of independent directors even in jurisdictions that don't require independent directors. These are all standards that we apply globally in our business. We believe that independent directors help provide the safeguards that allow us to engage in sound affiliate transactions in those jurisdictions where that is permissible. On the other hand, the fact that affiliate transactions are more freely permissible in other jurisdictions we find does allow more innovative products and greater availability of alternatives for investors with that protection of the independent directors.

Finally, for acquisitions involving financial services firms, the issues are, as you can imagine, very tricky. Dave touched on a number of them earlier. If the affiliated broker dealer is a major trading partner of the fund, is 17(a) prohibition on principal transactions going to be an unfair burden? Are the tentative three restrictions going to impede a fund? If the fund and a broker dealer both purchase loans and purchase from the same syndicate, do you have a joint transaction? What if the broker dealer receives a fee in a private placement in which the fund is participating? Is that a joint transaction? These are very difficult questions that come up all the time, and it might be worthwhile to take a fresh look, and tweak the regulatory structure, in light of the increasing global complexity and consolidation, because with further consolidation, and it is certainly inevitable that that is happening, there is clearly a risk that fund shareholders could be denied investment opportunities by the current constraints. Information barriers really can pose a solution that both provide the protections along with the diligent oversight of independent directors, but that could also benefit the shareholders. But, having said this, clearly, the job of independent directors is not getting any easier.

Mr. Butowsky:  Rachel, did I hear you say that there are numerous international businesses that Morgan has, and now that you have 20th Century, may I ask, are compliance issues presented when 20th Century wants to do business with those organizations?

Ms. Robbins:  Compliance issues are presented all the time, Dave. As I said, because we don't have a change of control, many of the tougher issues we've been able to avoid, but yes, that's why we communicate very frequently with them, and regularly.

Mr. Roye:  Thanks, Rachel. I would just throw out a question to the entire panel. In a number of these acquisitions, you have an acquiring firm who, you know, doesn't oftentimes come from a background where they're used to having mutual funds in their array of products, or you have a foreign company that is used to a different regulatory regime, different standards. How do directors, in reviewing the transaction, assure that the compliance functions stay in place, that the compliance perspective and approaches that you want to see, and that have been traditionally applied in your organization remain, in light of the acquiring firms and the controlling persons having a different background, a different perspective?

Ms. Driscoll:  Well, I'll take that one first, because for us it was easier, I suspect, than in other cases. In the Zurich-Scudder transaction, Scudder was going to remain the investment manager. Now, because Zurich had already merged with Kemper, we made it clear that, and I think it was the intention all along, that it would be Scudder's compliance and ethics program that would be the company wide program. And we were both comfortable and reassured, continually, that that would be the case, and we explored that issue in a lot of depth as to what had been the history at, you know, at other places, and what was the culture and intentions of the new company. But I think you have touched upon an issue. When you have companies, acquirers, that either don't have a history of American mutual funds, I think there's a bit of perhaps education coming from the directors to the acquirer, as to the standards that we have in this industry, including dealing with directors, that they're going to have to comply with. Joe?

Dr. Hankin:  I really don't have anything else to add to that. I mean, the Q&A is often known as a question and avoidance session, too.

Mr. Butowsky:  I've had a number of clients that have been acquired by international organizations. One of the things that they frequently do is have the senior executive officer of the acquiring company – I'm thinking of one situation in London – come over and assure the directors as to the extent of their commitment to compliance and to American rules and regulations. And then we've had people go over to that organization, examine their compliance systems and procedures, and see whether they present any problems. For example, in Japan, it's very tough to get anybody to tell you whether a transaction is a principal transaction or an agency transaction, although if it's a transaction that has an impact in the United States, you know that 17(e)(1) is applicable, and somebody is going to be on your case if you haven't done that compliance step.

Mr. Roye:  When these major transactions are often announced, they are, you know, lauded, and people talk about synergies in the press releases, and the benefits of the transactions. Are we seeing the benefits slide down to the mutual fund investor in these kinds of transactions? And this ties into a question from the audience. The question is, do directors have an obligation or should they, in some of these transactions, try to negotiate some of the purchase price for the benefit of the shareholders? It's not – you don't see that.

Ms. Driscoll:  Well, I can try and answer that one. You know, in our case, it wasn't that the adviser was cashing out. You know, it was more of a merger. And so, you know, there's no sort of pot of cash that you can distribute to the funds. But I think, to answer your first question, about the benefit to the shareholders, that's what we spent, you know, 25 meetings talking about: what are we getting here for the shareholders, and how can we measure it six months from now, a year from now, two years from now, three years from now, whether what we had expected really happened. I can just tell you, in our case, if a shareholder would have called me and asked, and said, you know, "A year later, what have you seen," I'd say, you know, even five years ago, I don't think I would have said the $100 billion company was too small. But in this day and age, it may be that you do need larger institutions for things like that I mentioned before: access to capital, 21st century technology, forget the year 2000 issues for a moment, issues of back office operations, you know, checks and balances, the things that you don't read about in the press that aren't kind of sexy to talk about, but what directors talk about all the time. Hopefully, an acquisition that's well thought out will bring you that. In the case of the Scudder-Kemper, you know, on our side, we got some very good fixed income managers from Kemper now working on some of the Scudder funds. And I suspect if you ask the Kemper folks, they would say that they got some very good international and equity folks from the Scudder side working on some of their funds. As I said, I think Scudder has a reputation for good compliance and values throughout the company, and to the extent that that was extended to Kemper and now globally to Zurich, I think that's a plus for all shareholders.

Dr. Hankin:  In my experience, the acquiring firms have been so market-oriented that they have been very cognizant themselves of the shareholders. If the independent directors didn't raise the questions themselves, which they have been, I think that they might have been raised anyway.

Mr. Roye:  Oftentimes, in connection with these transactions, the next step or even contemporaneously with the acquisition, the subject of merging and combining funds, you'll have duplicate funds coming from the respective groups that are coming together. Could you maybe touch on some of director considerations when you're combining funds, and what you focus on in those kinds of situations?

Dr. Hankin:  What is the objective of the funds and is the match a direct one or is it a forced match. As I indicated in my remarks, we in fact felt, in some instances, they were trying to force it into something which was inappropriate, and as independent directors, we refused to agree to it. And that was changed.

Ms. Driscoll:  We didn't – we had a little different situation. We didn't merge any funds, because we had two different distribution arms. So I suspect Joe has merged a lot more funds.

Dr. Hankin:  We actually have that right now, because there's a whole family of funds from Wells and a whole family of funds from Norwest, and some fit very comfortably and others don't, and so we're going through that whole exercise at this very moment.

Mr. Roye:  Dave, have you seen situations where the driving force for some of these mergers, I guess maybe special situations where the driving force for a transaction is actually emanating from the directors themselves?

Mr. Butowsky:  Well, sure. We see situations in which one of the funds is just not selling or is not performing, and there's a need for either a merger or a liquidation of the fund. It's no good for shareholders to have a fund that isn't profitable to the manager. That's one reason. It's a stick out reason. And there may be others, as well. Dawn-Marie, Joe?

Ms. Robbins:  I think that some of them were mentioned earlier, also, the need for more capital for technology. And all of those are very real. Access to a different client base, those are real drivers that I would think would drive that situation.

Mr. Butowsky:  By the way, I think that mostly the interests of the adviser and the interests of the directors and the interests of shareholders in 95 percent of these cases are the same. People want to have successful funds, funds that will sell, funds that should be merged because it makes sense. You just have to make sure that the expense ratios, the comparability, investment limitations, restrictions, all of those things, which are in detail in my memo, are taken care of, so that you can have a merger that makes sense and that won't be attacked.

Mr. Roye:  We've looked at, you know, situations where they don't quite fit within some of the exemptive rules, and directors have had to make findings that the transactions are in the best interests of the funds. And we've seen transactions where the combination of the funds results in a taxable transaction, the expenses of the surviving fund are higher than the fund that's disappearing, the expenses of the transactions are being borne by the funds themselves, and the directors have still made a finding that that's in the best interests of the funds. Any reaction, Dave, as to how they get there?

Mr. Butowsky:  Well, I didn't get a call on any of those.

Mr. Roye:  Okay. I think we've taken up our allotted time. I'd like to thank the panelists. We've had an interesting discussion. And we'll pick up with our next panel.

(Applause.)

Top   

Issues for Independent Directors of Closed-End Funds, Variable Insurance Products Funds, and Bank-Related Funds  

Mr. Gonson:  Good morning, ladies and gentlemen. My name is Paul Gonson. Until two months ago, I was the long-time solicitor of the Securities & Exchange Commission, and since the beginning of this year, I am a part-time consultant to the SEC, and counsel to the law firm of Kirkpatrick & Lockhart in Washington, DC

This panel is a three-bell ringer. The panelists will discuss the roles of independent directors in three specialized kinds of funds: closed-end funds, bank-related funds, and variable insurance products funds. Here is how we're going to proceed on this panel: we are going to do it a little bit differently than the previous panels, because of the three different subjects. We are going to divide the entire time for the panel in thirds. And, by the way, since we're starting late, we probably will run about 15 minutes or so into the lunch hour. First, two of our panelists will take the lead in discussing closed-end funds. Each of the two will make an approximate six-minute presentation. And then all of the panelists who wish to do so will chime in on the discussion and answer any questions. Then, second, we will continue this format with the panelists making presentations on bank-related funds, followed by a discussion. And finally, one panelist on variable insurance funds, followed by a discussion on that subject.

I would like to introduce all the panelists in alphabetical order, starting on my left, your right: Diane Ambler is a partner in the Washington, DC office of Mayer, Brown & Plat, and a contributor to the American Bar Association's Fund Directors' Guidebook. To her left, Kathleen Dennis is senior managing director of Key Asset Management, Inc., and is responsible for Key Corp.'s proprietary mutual fund business, the Victory Funds. And she is located in Cleveland, Ohio. To her left, Deborah Gatzek, is general counsel of the Franklin Templeton Group of mutual funds, and is responsible for operation of the legal and compliance departments, and she is located in San Mateo, California. I had promised her early spring weather, with the cherry blossoms just starting to bud.

(Laughter.)

Mr. Nolen:  Thank you very much. I think that what I am about to say will be made more interesting if I informed you that that article in last Friday's Wall Street Journal describing certain, quote, "independent directors" of certain closed-end funds described some as having a compensation that was the equivalent of as much as $400,000. I thought that was very interesting. That makes me – by process of elimination, I'm that person. That makes me not only the oldest person here, but presumably, the most highly compensated. Unfortunately, if the journalist had simply said that I was on this fund because I was young and handsome, I wouldn't have minded that, and would not have cared that there was no source for it and it wasn't true. But as to the $400,000 of compensation, you know, I just had to ask, "Show me the money."

(Laughter.)

(Laughter.)

Now, I'm going to go around and look at the history of these funds and why the discount exists, and what do we do about it. First, the closed-end fund has a very long history. The important ones, they were one of the most important part of investor – small investor participation in the market in the 1920s. Every great investment banking house sponsored one. The ones that weren't leveraged survived. Several of them are still extant, and they still have discounts after three-quarters of a century. At the same time, these fund, I could mention two, or several are mentioned in the footnotes in one of the papers you'll see here. Tri-Continental and General American Investors, after 75 years, still run with a discount. Now at the same time this was going on, two other kinds of mutual funds were developing. Scudder, a man named Scudder, invented something called the no-load fund, now called pure no-load. And you could get the same portfolio that you would buy through General American Investors with no commission charges and the rates were very low, and there was no marketing support for this. It grew very slowly. In the middle, there was another kind of fund which was an open-end fund with large front-end commissions, 4 to 7 percent. As it turned out, the market shares of these three funds developed in quite different ways. On the one hand, sophisticated investors took the Scudder-type fund, pure no-load. Some people took the closed-end fund. But since you could get the same portfolio in the middle fund, that is, the open-end fund, a lot of people took that. In the beginning, you would say, "Why does this exist?" Well, in those days, the marketing was all important.

Although these funds might have a management fee of 3/8th's of 1 percent, the brokerage, before Mayday, was huge, and the investment banking houses, with this huge amount of brokerage, could do some rather effective marketing. Although the management fee was peanuts, the profits were huge. Alongside of it was running these new open-end funds. Why were these fees as high as 7 percent? Well, if you look at what brokerage fees were at that time, 7 percent was roughly as much as the brokerage fee to go into close-end fund and come back out again. So the customer's man would get as much compensation, and he would get it in advance, by selling the new open-end fund, rather than the closed-end fund that had exactly the same content. So from these three types of funds went along through the market, and now we come down, 50 years later, 60 years later, and the open-end fund with commission or the open-end fund no-load dominate the market. Why, in the midst of all this, does the closed-end fund resurrect itself, because they make up only a small part? Im talking about a specific class of closed-end funds, which are the so-called country funds. There are bond funds, and a number of other things like that, that are proprietary products. They have great marketing support. And I won't go into why they have great marketing support.

We started with closed-end funds, with the country funds. And the first, the Japan fund was the first. It was actually introduced by an underwriting house and subsequently turned over to Scudder. It had this very interesting characteristic, that the Japanese market was not exactly open to all the investors. You couldn't buy that portfolio that was in the Japan fund. When it became possible to buy that portfolio, immediately that fund open-ended, so there was no reason to have it closed-end any more. But in the early '80s, it became apparent, something that we now call emerging markets attracted our attention. I'll divide these into two classes: those markets which were somnolent, or almost non-existent; and those markets which, like the ones in Europe, that were going to be subject to cataclysmic change, owing to the development of the common currency, et cetera. In the case of the high-risk country funds, the reason for it being closed in was that you had a country risk, a currency risk, political risk, and the usual things that go on in markets. It was deemed imprudent to try to have a fund that could be opened up so you would be selling into a firestorm. So that made sense, to close it.

In the case of Europe, you could have had a European fund that concentrated in, you know, 15 stocks, and it would have had extremely high liquidity, it would have gone very well. If you start trying to enlarge that to a market of 600 stocks, the liquidity situation looked more like emerging markets. At any rate, these funds started up, and the fascinating fact was that the Korea fund, the first launch, went to a huge premium. Nothing like it had ever happened before. This started out as a pool of cash with a license to invest in the Korean market, and all of a sudden, it went, for an instant, to a 200 percent premium. Nothing like it had ever happened before, which caused the underwriting community to go wild, and all sorts of country funds came along. The Korea fund, all these years later, still maintains a premium, but almost all the other funds since have sold at a discount. The problem, then, for the independent directors is what to do. In almost every prospectus, in every prospectus I know of, there is language about "The directors will consider this," and it has been going on, considering. However, it has turned out that the interest in open-ending is highest for the most successful funds. The Spain and Portugal fund, which is in the process of liquidation – the last trading day March 1st, liquidation day March 5th this year – was the most successful closed-end fund on the market in the years '97 and '98. A lot of the investors would like to have gone on with that record of success, but no, they voted for liquidation. We have just announced that a kind of open-ending will apply to the New Europe fund. Both of these funds would have been open-ended. From day one, we intended that when the markets matured, they would be open-ended. In our case, the directors had to make that decision. But let's look at what the problems were. There were a lot of different ways of open-ending, and the successful fund, open-ending a successful fund with this dollar discount creates a very interesting problem. There are your original investors. Now, these funds were ways of introducing, allowing smaller investors to go into a very high-risk market, and where they were extremely successful, they created huge embedded capital gains tax liability. When those funds are open-ended, any open-ending that doesn't result in liquidation means that it triggers a taxable event for all investors.

Mr. Gonson:  Mr. Nolen, as a fund director, is that a consideration that you would take into account, or do you think that disclosure would be sufficient, and then the investors could make up their own mind?

Mr. Nolen:  We have disclosure. The situation is clear-cut. There is disclosure on this. The problem is what do you do when different classes of investors have different interests? The investor who wants to go on doesn't want a taxable event.

Mr. Gonson:  When you take that into account, to what extent do you take into account the interests of those investors who were the original purchasers and still are there, and presumably want to continue, as against others who have come in later and would like to see it open-ended or liquidated? They both are, of course, stockholders. Don't they have equal claim on –

Mr. Nolen:  Yes, that is absolutely right. They have equal claim, and you are the director for all the stockholders. We had this ironic situation occur in one closed- end fund, which I am not involved in, where an absolute return investment group in Europe took up the position, got themselves elected directors, and found themselves in the embarrassing position of holding a very large holding in the stock. They then became inside directors. The profit on the transaction had to go to the fund, because they represented all the shareholders. But this is an anomaly, and I'm going to talk to you about it in this way: Laws have changed about distribution of capital gains since a lot of these funds became effective. When people make laws – you know, Bismarck made a lot of history, but he made one little comment in political philosophy. He said: "It's best that the public not know how either sausage or laws are made."

(Laughter.)

(Laughter.)

Mr. Gonson:  Mr. Nolen, I wonder now whether it would be a good time to turn to Deborah Gatzek, who might talk about, in addition to what else she was going to say, perhaps about the choices that are made at the outset when a closed-end fund is established? But first, I, too, have a disclaimer to make, as you made one, Mr. Nolen, about your $400,000. The chairman, Chairman Levitt, some time ago, indicated that people were being attracted away from the staff of the SEC with offers as much as $1 million. I would like everybody to know that I am not one of those $1 million men.

(Laughter.)

Ms. Gatzek:  All right. Let me begin at the beginning, perhaps, with this wonderful historical background that Mr. Nolen has provided us. You're an independent director, and at the outset, you have been asked to serve on the board of a fund that they tell you is going to be closed-end. Well, I would suggest, though, that the first thing you do is make sure that it makes sense for this fund to be a closed-end fund. We're not talking about 1920 or 1980. We're talking 1999. And generally, you should hear something along the lines of, there are valid portfolio considerations. Mr. Nolen alluded to this. What we find today is mostly going on are situations where a fund cannot really be run in an open-end format. My expertise would be in those emerging markets funds. Particularly I've got experience with Russia and Vietnam.

Well, I can tell you that there's no way that you could ever exploit the opportunities that many people see in those two jurisdictions, or people saw in those two jurisdictions, in an open-end format. You're talking about highly illiquid securities. And once you've made your disclosure to the investor that you're talking about a risky situation, you're talking about a place where there is no liquidity, once your investor agrees that he wants to participate in a place like Russia, a place like Vietnam, the only way to do it is in a closed-end fund format. You can't have money coming in, and you certainly can't have money unexpectedly going out. But you as independent directors want to hear management tell you that. You want to make sure that it makes sense. I think when that's the case, you can have a lot more comfort as you face some of the other issues that will inevitably confront you.

In my outline, I set forth a couple of other circumstances in which a fund might be closed-end, but I'm running out of time, so I'm going to kind of power through to what have you said in the initial prospectus about what you will do if there is a discount? You want to make sure that if you've said something very specific, that you understand what obligations you have undertaken, and you want to make sure that you fulfill them. On the other hand, if your language is somewhat more vague, you want to make sure that your prospectus makes it clear to all potential investors that you don't have a hard-and-fast plan, that you're not obligating yourself to take any particular action to address a discount. Very quickly, what are the reasons that a fund sells at a discount? The potential for the embedded capital gains is one of them. Some people say that closed-end funds trade at a discount because of a general lack of interest in the marketplace. Who even knows that these funds are out there? And if this is the case, and many people believe it is, I suggest that the industry and the SEC consider whether it might not be appropriate for closed-end funds to adopt something along the lines of a distribution plan pursuant to – well, it can't be 12(b)(1), because it doesn't apply, but some sort of a plan where the fund, out of its own assets, may pay brokers to service their shareholders in the fund. What that will do if it works right is to have brokers paying attention to the fund. They have to answer questions about the dividend. They have to answer questions that their shareholder clients may have about the portfolio. When a broker has that incentive to keep up his interest in the fund the next time a client comes in for whom that investment may be suitable he may suggest it.

There's another reason that these funds sell at a discount or a premium, and that's the good old fashioned forces of supply and demand. Studies have shown that when cash flows are very strong into open-end