Speech by SEC Staff:
Address at the Mutual Fund Directors Forum Second Annual Directors' Institute
Andrew J. Donohue1
Director, Division of Investment Management
U.S. Securities and Exchange Commission
Fort Myers, Florida
January 15, 2008
Considering that its thirty degrees or so back in Washington DC, I certainly appreciate being with you this evening in Fort Myers! It is hard to believe that it has been nearly a year since I gave the keynote address at the last Directors' Institute meeting. Although I would like to believe that the reason so many of you have returned is to hear me speak again, I suspect that your participation has less to do with my speaking abilities and more to do with the program. I applaud your diligence in tackling this year's case study that presents realistically some of the issues that you face as independent directors of mutual funds. Before I go any further, now is a good time to give the standard disclaimer that my remarks represent my own views and not necessarily the views of the Commission, individuals Commissioners or my colleagues on the Commission staff.
In anticipation of this evening Allan Mostoff and Susan Wyderko indicated that they thought this audience would be interested in my personal views on the annual review of the investment adviser contract, commonly known as the "15(c) process," including any suggestions for conducting it. Having spent more than a few years as general counsel to asset management firms, I am very familiar with the process and have a great appreciation for the challenges you as independent directors face in conducting the annual review of the adviser's contract. Indeed, the statute itself places a heavy responsibility on fund boards, particularly the independent directors, to conduct the 15(c) process and the legislative history underscores this important role.
Before commenting on the role of fund directors in conducting a contract review, I thought it would be helpful to put the 15(c) process in context so that we have a common understanding of the framework that led to where we are today. Accordingly, if you bear with me, I would like to give the 15(c) process an historical perspective from its inception to the present.
Section 15 of the Investment Company Act sets forth in detail the requirements that must be satisfied in order for a person to serve as an investment adviser to a mutual fund. Subsections (a) and (b), among other things, provide that the adviser must have a written contract approved by a vote of a majority of the outstanding voting securities and the contract may not be continued more than two years unless it is specifically approved at least annually by the board of directors or by the vote of a majority of the outstanding voting securities of the fund.
In addition to these requirements, Section 15(c), as enacted in 1940, is the genesis of the requirement for independent directors to vote annually to approve an investment adviser contract. Under Section 15(c), absent approval by independent directors, it is unlawful for a registered investment company to enter into, renew, or perform any contract with an investment adviser (or principal underwriter). Although the language in the 1940 version of Section 15(c) is a little different than its current iteration, the thrust of the statute has remained constant, namely, that a majority of independent directors is required in order to approve the mutual fund's contract with the investment adviser. However, unlike the current version, Section 15(c) as originally enacted allowed a vote of the majority of the outstanding voting securities as an alternative to the requirement that the independent directors vote annually to approve the contract.
Three decades after passage of the Investment Company Act, Congress enacted the Investment Company Amendments Act of 1970.2 These amendments provided significant emphasis to the 15(c) process in at least five respects. First, the amendments added a new Section 36(b) to the Investment Company Act which for the first time expressly imposed on the mutual fund adviser a fiduciary duty with respect to compensation or payments paid by the mutual fund or the shareholders to the adviser. Second, whereas previously only the Commission had express authority to initiate an injunctive action against a person (premised on a person being "guilty" of "gross misconduct or gross abuse"), under Section 36(b) both the Commission and shareholders were expressly authorized to initiate suit against the adviser and others based on the breach of this fiduciary duty. Third, in order to assist directors in fulfilling their responsibilities, Section 15(c) was amended to state that it is the duty of directors to request and evaluate, and the duty of the adviser to furnish, such information reasonably necessary to evaluate the advisory contract. Fourth, the amendments mandated that the voting requirements of the 15(c) process could be satisfied only by independent directors who cast their vote in person at a meeting called for the purpose of voting to approve the investment adviser contract. And fifth, the amendments deleted from Section 15(c) the alternative for shareholders to vote to approve the contract in lieu of the independent directors.
Although the 1970 amendments codified a fiduciary duty standard in Section 36(b), the statute does not articulate how to determine whether a breach of such duty had occurred. Instead, the legislative history accompanying the 1970 amendments indicates that the "sole purpose" of Section 36(b) "is to specify the fiduciary duty of the investment adviser with respect to compensation, and provide a mechanism for court enforcement of this duty."3 In connection with such enforcement, the Senate Report cautioned that one should not infer from this section any finding by the Committee on Banking and Currency that the then-present industry level of management fees or the fee of any particular adviser was too high. The Senate Report further observed that while Section 36(b) authorized the court to determine whether the investment adviser had committed a breach of fiduciary duty in receiving management fees, the section was not intended to authorize a court to substitute its business judgment for that of a mutual fund's board of directors in this area. Specifically, the Senate Report stated:
Directors of the fund, including the independent directors, have an important role in the management fee area. A responsible determination regarding the management fee by the directors, including a majority of disinterested directors is not to be ignored. While the ultimate responsibility for the decision in determining whether the fiduciary duty has been breached rests with the court, approval of the management fee by the directors and shareholder ratification is to be given such weight as the court deems appropriate in the circumstances of the particular case.4
I also note that the Congressional directive for the court to give due consideration to board approval and shareholder ratification or approval of the adviser's compensation is included in Section 36(b)(2) which expressly provides that such approval "shall be given such consideration by the court as is deemed appropriate under all the circumstances."
Another dozen years passed before the courts, in 1982, articulated factors to consider in determining whether a management fee is so excessive as to constitute a breach of fiduciary duty. I suspect that everyone in the room recognizes the name Gartenberg v. Merrill Lynch Asset Management, Inc.,5 in which money market fund shareholders brought an action against the fund, the fund's investment adviser and the broker affiliate alleging that compensation received by the adviser constituted a breach of its statutory fiduciary duty. Gartenberg is the seminal case which identifies a number of factors that may be important in determining whether a breach of fiduciary duty occurred within the meaning of Section 36(b). Specifically, the United States Court of Appeals for the Second Circuit stated that these factors include "the adviser-manager's cost in providing the service, the nature and quality of the service, the extent to which the adviser-manager realizes economies of scale as the fund grows larger, and the volume of orders which must be processed by the manager."6 The court also noted that financial "fall-out" benefits accruing to the adviser and its affiliates could be a factor if they were of "sufficient substance" that they should be offset against the adviser's fee. Shortly following Gartenberg, shareholders initiated a handful of additional cases alleging a breach of an adviser's fiduciary duty vis-à-vis management fees. Each of these cases uses similar factors to analyze whether a breach occurred including the resulting profits realized by the adviser and its affiliates from its relationship with the fund and a comparative analysis of expense ratios of similar funds and advisory fees paid to those funds.
In 1994 the Commission adopted a rule that required fund proxy statements seeking approval of an investment advisory contract to include a discussion of the material factors that form the basis of the fund board's recommendation that shareholders approve the contract.7 As initially proposed, the rule identified various discussion factors, stating that "these factors may include, among other things, the qualifications of the investment adviser, the range of services provided by the investment adviser, and the financial condition of the adviser."8 The Commission ultimately determined not to include a list of material factors in the requirement for a discussion of the recommended investment advisory contract out of concern that "enumeration of factors might lead to 'boiler plate' disclosure." Instead, the Commission stated that it "believe[d] that the material factors discussion should reflect the board of directors' evaluation of the investment advisory contract…."9
In 2001, the Commission required funds to disclose in the Statement of Additional Information the board's basis for approving the existing investment advisory contract.10 As noted in the proposing release, the required disclosure in the SAI was similar to the required disclosure in fund proxy statements.11
Fast forward to 2004 when the Commission adopted a final rule entitled Disclosure Regarding Approval of Investment Advisory Contracts by Directors of Investment Companies.12 This rule requires a registered investment company to provide disclosure in its report to shareholders regarding the material factors and the conclusions with respect to those factors that formed the basis for the board's approval of advisory contracts during the most recent fiscal half-year. The rule also encourages improved disclosure in proxy statements regarding the board's recommendation that shareholders approve an advisory contract. Although as noted the Commission in 1994 had determined that it would not require the enumeration of specific factors in the discussion supporting a recommendation to approve an investment advisory contract contained in a fund's proxy statement out of concern that it would lead to boiler plate disclosure, the 2004 rule adopted several enhancements to these proxy statement disclosure requirements that also became required disclosures in shareholder reports, namely: a) that the fund's discussion must include factors relating to both the board's selection of the investment adviser and its approval of the advisory fee and any other amounts to be paid under the advisory contract; b) that a fund must include a discussion of various factors similar to if not the same as those identified in the Gartenberg case; and c) an instruction clarifying that if any of the enumerated factors is not relevant to the board's evaluation of the investment advisory contract, the discussion must note this and explain the reasons why that factor is not relevant.
Given this historical perspective, one may ask — "Where are we today?" The short answer is that over the past 68 years the 15(c) process has evolved to the point where it requires the independent directors to engage, in person, in a detailed analysis of the investment advisory contract with each aspect of the analysis well documented. Although this necessarily has increased the amount of time independent directors devote to the 15(c) process, I believe that the result is beneficial for everyone — the investors, the fund, the adviser and the directors. Let me explain why.
As the Senate Report accompanying the 1970 amendments recognized, mutual funds and their investment advisers have a unique industry structure that generally does not exist in conventional corporate relationships.13 The adviser typically creates the fund and then operates it and investors buy fund shares relying on the adviser's services.14 Given the lack of arms-length bargaining between the adviser and the fund, the investment advisory contract must instead be approved by independent directors. Because both the adviser and the fund board know that the independent directors are required to engage in a detailed review and analysis of the adviser's compensation, this creates an incentive for both sides to work transparently and collaboratively to the benefit of the fund's investors. After all, as a practical matter, the primary threat that independent directors who do not approve of an adviser's contract have is what some call the "nuclear option," which is a vote not to approve the contract and instead obtain a replacement adviser for the fund. However, given the unique structure of the fund and its adviser, combined with the expectation of investors, replacing the adviser would most likely lead to mutually assured destruction because investors will flee the fund (if they can), it will close, and the board will be out of business.
An in-depth 15(c) process is not only beneficial to the fund and its investors, but also directly benefits the adviser and the independent directors. Specifically, I believe that a detailed 15(c) process minimizes the likelihood of a successful legal challenge. This is because the legislative history of Section 36(b) suggests that courts generally will not substitute their business judgment for that of the independent directors in the area of management fees and an adviser who provides robust information to the directors to enable them to make an informed decision whether to vote to approve the advisory contract obtains the benefit of the directors' business judgment. On the other hand, if the directors are not fully informed about all of the facts bearing on the adviser's services and fees, then a court may give less credence to the directors' judgment. Therefore, in order to evidence that an adviser has fulfilled its fiduciary duties, the adviser has strong incentive to provide the directors with detailed information about the adviser's compensation and services provided.
For similar reasons, the independent directors also have strong incentive to document fully and completely their decision to vote to approve the adviser's contract. Gartenberg and its progeny indicate that the expertise of the directors, the extent to which they are fully informed and the care and conscientiousness with which directors perform their duties also are factors to consider when deciding whether a breach of fiduciary duty occurred. If a shareholder attempts to challenge an adviser's fee, most likely the shareholder will need to establish that the business judgment of the independent directors who voted to approve the investment advisory contract should not be relied upon by the court. By extensively documenting their decision, the independent directors have a record demonstrating that they conscientiously performed their duties and, in my view, are more likely to have their business judgment relied upon. Moreover, a carefully documented record undermines a cynic's view that independent directors vote to approve the advisory contract in order to keep their jobs.
Rather than continuing to discuss the 15(c) process and risk causing anyone's eyes to glaze over, I would like to spend my few remaining minutes talking more broadly about independent director duties generally. As many of you know, last year I started my "Director Outreach Initiative." The purpose of this initiative is to find out whether fund directors, in light of the increased duties that have been imposed on them in the past few years, continue to be in a position to perform their duties effectively.
Throughout 2007 I attended numerous mutual fund board meetings and asked directors about their jobs. I received a lot of good feedback and, as you might expect, there were some recurring themes. The two biggest topics by far that fund directors have discussed with me are Rule 12b-1 fees and soft dollars. I've previously spoken at length about these topics so in the interest of time I won't repeat myself here other than to note that, separate from my Director Outreach Initiative, my staff is already hard at work analyzing both of these issues. In addition, many directors expressed their strong desire for a revamping of the requirement for the board, on a quarterly basis, to review transactions with affiliates. Directors also suggested that they should be able to delegate to others (the chief compliance officer was most often mentioned) certain of their duties in order to free up their time to devote more attention to substantive issues. I am particularly interested in this latter point and my staff is analyzing whether it makes sense for you to delegate certain duties, and if so, to whom and to what extent, in order to create better efficiencies. As we approach this exercise, my staff is focused on the fact that directors are overseers — not executives who are involved in the day-to-day details of running a business.
In conclusion, let me restate that I welcome your continued feedback. For 2008 I plan to continue to attend fund board meetings, albeit on a less rigorous schedule. In addition, my door and mailbox are always open if you would like to share any thoughts about your duties as independent directors and suggestions for what, if anything, the Commission should consider or can do to make the performance of these duties more effective. Likewise, feel free to contact my staff with your thoughts.
Thank you for again inviting me to join you at this conference and I am happy to answer any questions.