Speech by SEC Staff:
Remarks before the Fund Governance Program Presented by the Mutual Fund Directors Forum and Fund Directions
Paul F. Roye1
Director, Division of Investment Management
U.S. Securities and Exchange Commission
New York, NY
December 9, 2004
The Role of Independent Fund Directors
Good afternoon and thank you for your welcome. Before I begin, I would like to remind you that, as always, my remarks represent my own views and not necessarily the views of the Commission, the individual Commissioners or my colleagues on the Commission staff.
It is a pleasure to be with you here today to debate best practices and review our regime of fund governance. Today, I would like to discuss the role of independent directors, focusing on three main functions of mutual fund directors: (1) managing conflicts of interest; (2) approving the advisory contract and advisory fees; and (3) selecting and nominating candidates for independent directors. Each of these roles is discussed in detail in the Commission's release adopting its most recent fund governance reforms. I also want to provide some insight on the new role of the independent chairman.
II. The Role of Independent Directors
A. Managing Conflicts of Interest
As you know, the Commission recently adopted amendments to its rules to improve the governance standards of investment companies. These amendments provide for greater independence of fund boards in the case of funds that rely on certain exemptive rules that allow funds to engage in transactions that would otherwise be prohibited under the Investment Company Act and that present conflicts of interest between the fund and the management company. The Commission adopted these amendments, along with a number of other initiatives, in the wake of issues that emerged during the mutual fund scandals. The Commission's recent enforcement actions in many cases reflected a serious breakdown in management controls as well as instances in which funds were used for the benefit of fund insiders, often the management company or its employees.
The rule amendments were also designed to address broader concerns with the governance of mutual funds. The Commission noted that a fund adviser is frequently in a position to dominate a fund's board because of the adviser's monopoly over information about the fund and its ability to control the board's agenda. The Commission questioned the ability of a management-dominated board to undertake many important tasks assigned to the board by the Act and our rules, including negotiating the advisory fee, approving rule 12b-1 plans and resolving conflicts between the fund and the management company.
As the Commission has said, to be truly effective, a fund board must be an independent force in fund affairs rather than a passive affiliate of management. Its independent directors must commit their time and energy, and devote themselves to the principles set forth in the Investment Company Act and state corporate and trust law under which funds are organized.
While the Investment Company Act contains many important requirements with which a fund must comply, the paramount principle that must prevail, and should animate all decisions directors make, is that a fund must be managed on behalf of its investors rather than on behalf of the adviser or other affiliated persons of the fund. Directors, therefore, should be highly skeptical of arguments that merely rationalize the resolution of conflicts in favor of the fund adviser, and should seek results that advance the best interests of fund shareholders.
The Commission has long recognized the important role that independent directors play in managing conflicts. This recognition is evidenced in part by the Commission placing reliance on independent director oversight in connection with many of the transactions permitted by its exemptive rules. Each of these transactions involves potentially serious conflicts of interest between funds and their managers, and would otherwise be prohibited by the Investment Company Act. For many years, the exemptive rules have been conditioned upon the judgment and scrutiny of the funds' independent directors to oversee these inherent conflicts of interest, and I encourage you to continue to approach conflict-laden transactions with vigilance and a healthy dose of skepticism.
I also encourage you to take full advantage of the new role of the fund CCO in your efforts to oversee conflicts of interest. In addition, I hope that the recent effort to review compliance policies and procedures has been therapeutic and an opportunity to rethink practices and ways of doing business, and that your fund groups and their service providers have addressed or eliminated conflicts of interest and practices that can compromise investor interests.
A fund's CCO can be an important resource for you in helping to identify conflicts of interest and ensuring that controls are in place to manage those conflicts. As you know, part of the job of a CCO is to monitor the effectiveness of a firm's compliance policies and procedures, and we envision that this monitoring will include periodic testing of the procedures to ensure that they are working. You should be requesting information from your CCOs about the results of this kind of testing-with a particular emphasis on ensuring that the procedures in place are effective in controlling conflicts of interest.
Similarly, when your CCO reports to you regarding material compliance matters that have been detected, you should question your CCO regarding what compliance changes are being put in place to address these matters and why they will be more effective. If no compliance changes are being made in light of material compliance problems, you should be asking why not.
I further encourage you to fully and carefully consider the recommendations in the Mutual Fund Directors Forum's Best Practices Report on ways to enhance the effectiveness of independent directors with respect to conflicts of interest. Clearly, you appreciate the importance of these recommendations because you are here today to broaden your understanding of their impact and implications. I am pleased that the Forum, and its independent director members, responded enthusiastically to Chairman Donaldson's call and developed comprehensive best practices for independent directors in a variety of areas where directors' oversight is essential, including soft dollars, directed brokerage, revenue sharing and valuation and pricing. Significantly, one of the Forum's recommendations with respect to conflicts of interest oversight is that independent directors participate in ongoing educational programs designed to enhance knowledge of issues relating to fund oversight. Certainly, those of you in this room have heeded that advice and are testament to the commitment that independent directors exhibit to staying on top of issues in order to better serve fund investors.
I fully understand that conflict oversight and management is not always easy-but it is a core part of your responsibilities as independent fund directors, particularly because of the conflicts inherent in the external management structure of mutual funds. Because of these conflicts, you should approach issues with a healthy dose of skepticism and a commitment to questioning transactions and other arrangements that could have a direct, or indirect, benefit to fund management at the expense of fund shareholders.
B. Approving the Advisory Contract and Advisory Fees
Section 15(c) of the Investment Company Act prohibits a person from serving as an investment adviser to a fund except pursuant to a contract that has been approved by a majority of directors who are not parties to the contract or interested persons of any such party, i.e., the independent directors. Section 15(c) requires fund boards to consider whether to approve the terms of the contract, including the amount of the advisory fee based on, among other things, information provided by the fund adviser. As the Commission has stated, these procedural requirements do not supplant the state law duties of loyalty and care that oblige directors to act in the best interest of the fund when considering important matters the Act entrusts to them, such as approval of an advisory contract and the advisory fee. Nor does the disclosure of the advisory fee in the prospectus relieve independent directors of the obligation to negotiate the amount of the fee and to assure that fund shareholders share in the economies of scale achieved by the growth in fund assets, by, when appropriate, reducing advisory fees.
Section 15(c) also provides that the directors of a fund have a duty to request and evaluate, and the investment adviser has a duty to furnish, the information reasonably necessary to evaluate the terms of an advisory contract. Directors should frame their information requests broadly to obtain complete information relevant to their consideration of the advisory contract, and should include inquiries related to the adviser's material conflicts of interest with the fund and how the adviser deals with those conflicts. I believe that section 15(c) and section 206 of the Advisers Act, taken together, mandate an affirmative obligation, on the part of advisers, to disclose material information regarding conflicts of interest to the fund and its board.
In addition to fund directors' obligations with respect to advisory contracts, the statute also requires fund directors to annually approve a fund's principal underwriting or distribution agreement. The costs associated with a fund's distribution can be significant, and distribution arrangements can involve a variety of complex arrangements that require significant probing, questioning and examination on the part of fund directors. I encourage you to closely focus on this aspect of your director responsibilities.
The importance of your role in the review and approval of advisory and distribution contracts cannot be overstated. The scrutiny of fund fees is one of the most important obligations of independent directors. Here again, the Mutual Fund Directors Forum has developed helpful best practices for review of management contracts and management fees. You should carefully consider these and other methods to improve the effectiveness of your boards' contract review processes.
The Commission has stressed that fund shareholders stand to benefit substantially when the process of negotiation between fund independent directors and investment advisers leads to lower fees. In connection with some of the mutual fund enforcement actions of the past year, the Commission has refused to make fee reductions a component of settlements. Instead, the Commission has expressed its belief that the best way to ensure that funds obtain fair and reasonable fees is through a marketplace of vigorous, independent and diligent mutual fund boards, coupled with fully informed investors who are armed with complete, easy-to-digest disclosure about the fees paid and the services rendered. You, as independent directors, represent half of this equation, and you must be committed to performing this critical role.
Of course, the other half of the equation involves straightforward, easy to-understand disclosure about fund fees and expenses so that investors can evaluate for themselves the level of fund fees they are paying. The Commission is focused on ensuring that investors have the type of transparent fee information that they need. A new requirement regarding dollar-based fee information has recently been implemented for shareholder reports; the prospectus fee table has been a useful tool for investors and the financial advisors to compare costs across funds; and the Commission is continuing to look for other ways to get critical fee information into the hands of investors in a disclosure format that is easy for them to understand. For example, we are considering ways that we can provide investors better information regarding transaction costs, as we analyze comments we received in connection with the concept release the Commission issued on this topic last December.
With you fulfilling your role regarding the scrutiny of fund fees, coupled with fulsome disclosure to investors regarding fees, the market can then work and influence the level of fees in the fund industry.
C. Selecting and Nominating Candidates for Independent Directors
I would now like to discuss another of your critical functions: selecting and nominating candidates to serve as independent directors. Because of the conditions placed on the exemptive rules, the incumbent independent directors of most funds have the responsibility to select and nominate new independent directors. The Investment Company Act provides minimum criteria for persons to qualify as independent directors, and independent directors who satisfy those criteria meet the requirements of the Act.
The Commission has urged independent directors to look beyond those requirements and examine whether a candidate's personal or business relationships suggest that the candidate will not aggressively represent the interests of fund investors. As the Commission has stated, persons who have served as executives of the fund adviser or who are close family members of employees of the fund, its adviser or principal underwriter would be poor choices for candidates, although they may meet the minimum statutory requirements.
The Commission has recognized that "legal" independence may not equate with "real" independence. Indeed, the Mutual Fund Directors Forum underscored this point by recommending best practices for director independence that go beyond the requirements in the Investment Company Act. I therefore encourage you, in selecting and nominating other independent directors, to identify individuals who have the background, experience, and independent judgment to represent the interests of fund investors. I also encourage you to look for candidates who have backgrounds or skill sets that may complement the qualifications of your current board members.
I also encourage you to engage in full-scale searches when you are considering new independent director candidates. A review of a single resume or a quick meeting with a potential board candidate suggested by management does not constitute a "full-scale search." Independent directors should be leading the process of independent director candidate selection and nomination-not merely rubberstamping candidates suggested by management. Thus, you should be engaging in a full, responsible and deliberate process when considering independent director candidates.
III. Independent Chairman
The rules recently adopted by the Commission will require funds relying on certain of our exemptive rules to have an independent chairman. A majority of the Commission was of the view that a fund board would be in a better position to protect the interests of fund shareholders and to fulfill the board's obligations under the Investment Company Act and the exemptive rules, when a fund's chairman does not have the conflicts inherent in the role of an executive of the fund adviser.
A. Crafting the Role of the Independent Chairman
A preliminary challenge for any fund board and new independent chairman will involve crafting the role of an independent chairman, especially for a fund board that historically has been chaired by a management representative. The new requirement provides that a fund's independent chairman preside over meetings of the board of directors and have substantially the same responsibilities as would a chairman of a board of directors. I believe that the Commission anticipates that independent chairmen will fill a leadership role. At the very least, independent chairmen will (i) have charge over a fund's board meeting agenda, (ii) determine what information is provided to the board, (iii) run and establish the tone and tenor of board meetings and (iv) serve as a spokesman for the independent directors. In addition, the independent chairman can serve a liaison function with management, the board, and potentially investors and regulators.
The independent chairmanship, however, is not an executive position. The independent chairman is not meant to be responsible for administering the day-to-day operations of the fund. The board's role (and the independent chairman's) continues to primarily be one of oversight.
When the independent chairman's role is crafted, consideration should be given to the chairman's support infrastructure, including staff if necessary. On this point, I would note that the Commission has been very clear. The decision regarding whether independent directors should hire staff is one for the directors, and not the adviser, to make. There may be a variety of reasons why management may not favor separate staff for independent directors. However, it is you, and not management, who must determine what your staffing needs are in light of your duties and responsibilities to fund directors. Again, when you are considering staffing needs, I encourage you to take full advantage of the CCO position as a resource for the board on compliance matters, keeping in mind that the CCO is ultimately answerable to a fund's board.
B. Selection of the Independent Chairman
I would like to say a word about the selection of an independent chairman for those of you who do not already have an independent director as the chairman of your board. When considering an independent chairman, you should look for someone who is willing to put in the time to lead the board. Also look for someone who is an effective communicator. The independent chair position requires communication, at a minimum with management, with fellow board members and with a fund's CCO, as well as potential communication with investors and regulators.
Perhaps most importantly, you should select an independent chairman who will be willing to stand up to management when necessary. In many ways, I believe the Commission intended the independent chairman to be a counterweight to management-and to buffer the control and influence that management can have in the boardroom. The Commission has acknowledged that "a crucial challenge to every fund board involves establishing an appropriate balance between cooperation with the management company and oversight of the management company." In the independent chairman, the Commission envisions a strong person who is not afraid to tackle difficult issues and confront management as necessary-and someone who is willing to say "NO" when appropriate. However, the position is not meant to be counterproductive or overly adversarial. As with the activities of any director, the guiding principle for an independent chairman should be a constant focus on the needs and interests of fund investors.
These are just a few of the considerations to take into account when selecting a new independent chairman. Of course, you also should consider factors that are particular to your own fund board situations. But I do encourage you to engage in a full and robust process when considering your independent chairman.
In conclusion, I want to thank you for the time, effort and dedication that you put into your increasingly challenging role as independent mutual fund directors. I know it is not always easy, and I know the responsibility and pressure can be substantial. As Chairman Donaldson recently stated,
The job of an independent fund director is not for the inattentive. It requires time, commitment, and dedication. The independent director role also is not for the faint of heart. Mutual fund investors rely on your vigilant oversight to ensure the responsible management of their assets. Your responsibility is significant - and the consequences if you fail can be severe, especially for the investors you are charged with protecting.
This past year has been a difficult one in many respects. Independent mutual fund directors have been in the spotlight like never before. Your oversight has been critiqued and, in some cases, your vigilance and attention to detail has been called into question. As I recently told a gathering of the fund industry, I do not expect this spotlight on your investor protection role to fade.
There are over 91 million investors who are invested in mutual funds. Americans rely on mutual funds as their primary investment vehicle when saving for retirement, planning for educational expenses or seeking investment exposure to our nation's securities markets. As a result, I think mutual funds, and their oversight and management, will continue to be front page news for years to come. The scandals have made all of us, including investors, realize the importance of mutual funds to our nation's economy, and the focus on your critical role in overseeing mutual funds and their managers will not subside. Thus, I challenge you to redouble your efforts, commit your energy and attention and continue your focus on the needs and interests of fund investors.
Finally, I encourage you to reach out to the Commission staff, as necessary. We want to help you do your job better. There is no doubt that the Commission relies significantly on independent directors; you should be able to rely on us when you have questions or are in need of interpretive guidance.
Thank you for your attention.