Speech by SEC Commissioner:
Remarks at Independent Directors Council's 2009 Investment Company Directors Conference
Commissioner Troy A. Paredes
U.S. Securities and Exchange Commission
Amelia Island, Florida
November 13, 2009
Thank you for the warm introduction. Before I begin, I must tell you that the views I express here today are my own and do not necessarily reflect those of the Securities and Exchange Commission or my fellow Commissioners.
It is a pleasure to be joining you here in Florida at the 2009 Investment Company Directors Conference hosted by the Independent Directors Council (IDC). Since its founding in 2004, the IDC has been an important forum for educating and informing investment company independent directors. I welcome the IDC's continued efforts to improve the effectiveness of mutual fund boards, and I appreciate the IDC's ongoing active participation in the regulatory process.
In my time this morning, I am going to address three topics, each of which speaks to the board's role: governance; the Jones case; and investor choice.
Governance and the Deliberative Process
Independent directors play a critical role in fund governance. Not only are independent directors charged with certain regulatory responsibilities, but the judgment of independent directors can help improve fund operations and performance more generally.
Whether one is considering the board of a fund or an operating company, whenever the board of directors is discussed, the same core question arises: What makes for an effective board of directors? More particularly for those in the audience today, what makes for an effective independent director?
When evaluating boards, attention routinely focuses on board composition and structure and the frequency of meetings.1 How many independent directors does a board have? What constitutes "independence"? Is the chairman independent? If the chairman is not independent, is there an independent lead director? What committees has the board constituted? How often does the full board meet? How often do key board committees meet and what transpires at the meetings? How often do independent directors meet separately?
These are all appropriate inquiries. But what matters most is not how a board is composed or structured or how many meetings are held each year. What matters most is how directors act.
Boards of directors are expected to improve decision making by spurring deliberation. In acting as a body, the promise is that boards will draw on the distinct perspectives, experiences, sensibilities, and expertise that different directors offer. The expectation is that as the group works through a range of ideas and arguments, the ultimate decision will be better as a result of the directors' collective efforts.
The active engagement of directors is a lynchpin of meaningful deliberation. Decision making should improve when directors — whether interacting with each other or with management — engage in open and frank discussions, even if it means being critical. When assessing some course of action, directors should ask probing questions and follow-ups of each other and of management; should challenge key assumptions; should offer competing analyses; and should develop competing options to ensure that alternatives are considered and not cast aside too readily. Put differently, directors should be willing to dissent, and disagreement from others should not be discouraged or suppressed. When it leads people to engage rigorously, disagreement helps ensure that the unknown is identified, that information is uncovered, and that challenges and opportunities are assessed in a more balanced way. Indeed, a board may want to consider designating one or two directors whose express charge is to be skeptical and to press when needed.
Peter Drucker, the influential management consultant and professor, expressed a similar sentiment this way:
Decisions of the kind the executive has to make are not made well by acclamation. They are made well only if based on the clash of conflicting views, the dialogue between different points of view, the choice between different judgments. The first rule in decision-making is that one does not make a decision unless there is disagreement.2
However, there is a word of caution. Disagreement and spirited deliberation should not give way to hostility. Distrust and disharmony can threaten an enterprise; boards need collegiality and cooperation. Dissent will be most constructive, then, when conflicting viewpoints and pointed resistance do not trigger defensiveness, but instead are encouraged as catalyzing better decisions.
Jones v. Harris
The role of the mutual fund board — and of independent directors especially — has been in the spotlight this year in the case of Jones v. Harris Associates L.P.,3 pending before the Supreme Court. At issue in Jones is the appropriate level of scrutiny courts should apply in reviewing investment advisory fees under section 36(b) of the Investment Company Act. On one level, the case centers on the extent to which an adviser's fiduciary duty limits the fees a mutual fund adviser can receive. On a separate level, the Jones case is about the extent to which courts should refrain from overturning the good faith business judgment of independent directors.
As you know, in the 1982 Gartenberg case,4 the Second Circuit found that for an adviser of a mutual fund to violate the section 36(b) fiduciary duty, the adviser's fee must be "so disproportionately large that it bears no reasonable relationship to the services rendered and could not be the product of arm's-length bargaining."5 Gartenberg went on to provide important industry guidance by highlighting a number of specific factors for mutual fund advisers and boards to mind in negotiating the advisory fee.6
In Jones, the Seventh Circuit deviated from Gartenberg, placing greater emphasis on the extent to which competition keeps advisory fees in check. Stated simply, Judge Easterbrook reasoned that, because investors care about after-fee returns, competition among mutual funds limits the fees that investment advisers can charge. The Jones court built on its characterization of how the mutual fund industry has become increasingly competitive since Gartenberg was decided and streamlined the test for a section 36(b) violation as follows: So long as the adviser "make[s] full disclosure and plays no tricks," according to the Seventh Circuit, the adviser meets its fiduciary responsibilities.7
The Supreme Court heard oral argument in Jones early last week on November 2. A great deal could be said about the case and the oral argument. I will offer a few observations.
First, it is notable that neither side embraced Jones, a point that Justice Sotomayor brought out in her questioning of counsel for Harris Associates. Justice Sotomayor remarked: "Are you disavowing the Seventh Circuit's approach? Because I read your brief and it doesn't appear as if you are defending their market approach . . . ."
As the Justice's question suggests, the crux of the matter is not about choosing between Jones and Gartenberg. Rather, the open issue seems to concern the appropriate application of Gartenberg going forward. The questioning at the oral argument focused on three primary considerations: (1) whether competition disciplines advisory fees; (2) whether section 36(b) contemplates a substantive cap on fees to ensure that fees charged are "fair" and "reasonable"; and (3) whether the fees charged institutional funds set a benchmark for determining the fees an adviser can charge retail funds.
Chief Justice Roberts struck at a central tension in the case, suggesting that market discipline may keep advisory fees in check. The Chief Justice stated in questioning counsel for the investors: "These days all you have to do is push a button and you find out exactly what the management fees are. I mean," he continued, "you just look it up on Morningstar and it's right there and . . . as an investor you can make whatever determination you'd like, including to take your money out." Chief Justice Roberts added that "[i]t takes 30 seconds" to switch funds if an investor is disgruntled over fees.
Justice Scalia echoed the suggestion that competition keeps fees in line, asking: "[W]hen investors leave the company that is charging excessive fees to go to other companies, the company that they are leaving sees that something's wrong and has to lower its compensation to its adviser. Why doesn't that affect the company at issue?"
The questioning of Chief Justice Roberts and Justice Scalia illuminates a significant point — namely, competition in the mutual fund industry may obviate the need for more demanding judicial scrutiny of advisory fees. One can conceive of the section 36(b) fiduciary duty as compensating for a lack of competition in the mutual fund industry. But the industry has changed since 1970 (when the provision was adopted) and 1982 (when Gartenberg was decided). To the extent the industry has become more competitive, it may argue for greater judicial deference to the bargain the adviser and the fund strike. In the face of sufficient market forces that constrain advisory fees, the need for courts to monitor as strictly adviser/board fee negotiations is mitigated. Even if the Jones approach is not warranted, a determination that meaningful market-based accountability disciplines advisory fees would argue against refashioning Gartenberg to give courts more control to set adviser compensation.
Justices Sotomayer and Breyer pointedly asked how to account for the "fairness" and "reasonableness" of advisory fees when assessing whether a section 36(b) fiduciary duty breach had occurred. Justice Sotomayer asked counsel for the investors: "[C]an I unpackage your argument a little bit. Because using the word 'fair fee' in my mind is meaningless, because it has to be fair in relationship to something. And so what is your definition of what that something is that it's fair to . . . or unfair against?" Counsel responded, consistent with Gartenberg, that a "fair" fee reflects "what an arm's-length agreement would produce." Justice Sotomayer then cut to the chase, asking: "And let's go to what seems to be part of your argument and sort of what everyone's skirting around, which is what's the proof that a particular transaction is not arm's-length?"
Along the lines of Justice Sotomayer's questioning, Justice Breyer expressly pressed on the meaning of Gartenberg's "so disproportionately large" standard. Justice Breyer questioned counsel for Harris Associates:
What do we do about Gartenberg? That is to say, the key sentence you can read either way. The key sentence could mean — it just depends on the tone of voice. You must charge a fee that is not so disproportionately large that it bears no reasonable relationship to the services rendered and . . . could not have been the product of arm's-length bargaining. Or you could say . . . it's unlawful where it's so large . . . where there is no reasonable relationship. And if there is no reasonable relationship, how could it have been the product of arm's-length bargaining?
Let me offer a view. An especially large advisory fee that appears to be "disproportionate" would seem to evidence that the decision-making process that produced the fee was inexcusably tainted, such as by disloyalty or inadequate care, giving rise to a section 36(b) fiduciary duty breach. However, if on further scrutiny a court determines that careful, conscientious, and disinterested mutual fund directors agreed to the fee, little, if any, room is left for the court to declare that the fee is nonetheless so large — that is to say, unfair or unreasonable — that it could not be the result of an arm's-length bargain as the fee would, in fact, appear to be the result of just such a transaction. If a faithful, diligent board decided that the fee was appropriate, it would seem to rebut any preliminary determination, based on the size of the fee, that the fee ran afoul of section 36(b).
This analysis builds on a more foundational point: Courts are not well-positioned to second-guess the business decisions that boards or others in business make in good faith. Judges may exercise expert legal judgment, but not expert business judgment. A judge may be equipped to monitor a board's decision-making process, but should steer clear of the temptation to override substantive outcomes. These sensibilities cut against reading section 36(b) as implementing some sort of a cap on fees based on a court's determination of what is substantively "fair" or "reasonable." That directors perhaps could have struck a better bargain is a slim justification for allowing judges — who have no comparative expertise negotiating or setting advisory fees — to substitute their judgment for the collective judgment of independent directors acting in good faith.
Seeming to acknowledge the limited ability of courts to determine the appropriate level of fees, Chief Justice Roberts inquired of the investors' counsel:
[W]hat if the adviser had given such good advice that the fund beat the industry average for his category of fund by five percent over the last five years. Does he get double the normal compensation of the average fees? Does he get triple? Fifty-percent more? How is the court supposed to decide that?
Justice Sotomayor similarly asked the Assistant to the Solicitor General how to determine the "scope of the range" that could result from arm's-length bargaining and at what point "deviance" outside the range would trigger a section 36(b) violation.
Finally, a strand of questioning at oral argument focused on the relevance of comparing retail fund advisory fees with fees charged to institutional funds. Justice Ginsburg, for example, observed that the "investment adviser did disclose . . . the difference between what were charged mutual funds, what were charged institutional investors, and then explained that the services were different and that justified the difference." Justice Ginsburg also acknowledged a footnote in Gartenberg rejecting the argument that the disputed money market fund fees in that case should be benchmarked against the lower advisory fees large pension funds were charged.
Justice Breyer more directly asked counsel for Harris Associates: "Suppose you were appointed to a committee, just set my pay, that might be helpful. I'd say I'll pay you $50,000 a year to do it, as long as I am satisfied with your results." The Justice continued: "Now, would you . . . not have in your mind, I would like to know what he's paid by other people that don't have someone like me setting his pay? Wouldn't that be in your mind?" Justice Breyer concluded that it would be "pretty unusual" for such pay comparisons not to be "relevant."
Justice Breyer, however, did not suggest that advisory fee comparisons should be "dispositive." Justice Breyer did not indicate that fees charged to retail funds could not exceed fees charged to institutional funds or that there should be some fixed relationship between institutional and retail fund fees. I would add that if the Court were to require a comparison of fees, judges still should not second-guess the substance of the independent directors' good faith evaluation of the fees charged different funds and the reasons justifying any fee differences. To say that the board is to consider a particular factor should not dictate how that factor is considered and how it impacts a final fee determination. Simply put, fee comparisons should not morph into fee caps.
Like you, I look forward to the Court's opinion. Whatever the outcome, I hope that the Court speaks with sufficient clarity so that mutual fund boards and advisers understand what is required of them and can organize their affairs accordingly.
The history of the fund industry is one of providing investors with choices. As a result of innovations that lead to new product offerings, investors can choose among numerous variations of equity funds, bond funds, international funds, money market funds, and government funds. ETFs are a relatively new option for investors, separate from the myriad mutual funds that are available. From 1993, when the product launched, to 2007, before the peak of the financial crisis, ETFs grew to number over 6008 with total assets exceeding $600 billion,9 according to industry estimates. At the end of 2008, total assets in ETFs stood at $531 billion and there were 728 funds.10 In addition, 2008 saw actively-managed ETFs become available for investors. Other new products have been innovated over the years, although not always enjoying the same success as ETFs.
The kind of investor choice the fund industry offers is significant. One size of investment does not fit every investor. Choice allows investors to tailor their investments as they see fit to meet their individual investment goals, time horizons, risk tolerances, economic forecasts, and strategies. Choice also allows investors to hold diversified portfolios that reduce their risk.
The benefits of investor choice, including tailored portfolios, the chance to earn higher returns, and diversification, are important aspects of the SEC's mission of investor protection. Investor protection is about serving the broad interests of investors; it is not limited to shielding investors from fraud and manipulation. A market environment that affords investors the choice they desire so they can allocate their capital among a host of diverse options advances important investor goals. Board members play a key role in helping to shape this environment by influencing the innovation that occurs.
I expect product innovation to continue contributing to the industry's development and the welfare of investors. Ultimately, the marketplace is the best test of a new financial product. For a new product to succeed, investors must view the product as a good one and be willing to invest in it. The goal of providing products that investors will continue to want, therefore, drives product development. In addition, one must recognize that regulators themselves are not well-equipped to "sign off" on the substance of new products through some sort of merit review. This recognition is part and parcel of the disclosure philosophy of the federal securities laws.11 Federal securities regulation is animated by the view that, when armed with information, investors are well-positioned to evaluate investment opportunities, which is to say that more substantive regulation that would have the government decide whether a product is or is not appropriate for investors is unwarranted.
This is not to say that investors do not sometimes make errors or regret their investment decisions in hindsight. But over the long run, the collective judgment of the marketplace is preferable to the judgment of an individual regulator or a small group of government officials as to what products should be offered to investors. With adequate disclosure, investors remain best-equipped to decide how to allocate their capital.
Through improved disclosure and investor education, the SEC continues to empower investors in making informed investment decisions. Two examples illustrate the Commission's efforts.
First, in 2008, the SEC adopted rules providing for a mutual fund summary prospectus.12 By streamlining the information made available to mutual fund investors, the summary prospectus goes a long way toward stemming the problem of information overload, thus leading to a more effective disclosure regime. By giving investors significant information in a more understandable and digestible format, the summary prospectus promises to improve investor decision making.
Second, the SEC staff and FINRA recently issued a joint investor alert addressing leveraged and inverse ETFs.13 The alert was released because of concern that investors may be confused over the performance goals of these types of funds. As the alert explained: "Investors should be aware that performance of these ETFs over a period longer than one day can differ significantly from their stated daily performance objectives." Among other things, the alert posed a number of real-life examples showing how these funds perform and highlighted for investors several "things to consider before investing."
Investor education enhances the efficacy of the disclosure regime at the core of the federal securities laws. Providing effective investor education, therefore, is one of the SEC's key responsibilities.
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There is much more to say on many more topics. For now, let me end by saying thank you for your attention this morning. Enjoy the rest of the program.