Proposed Rule:
Role of Independent Directors of Investment Companies

SECURITIES AND EXCHANGE COMMISSION

17 CFR Parts 239, 240, 270 and 274

[Release Nos. 33-7754; 34-42007; IC-24082; File No. S7-23-99]

RIN 3235-AH75

Role of Independent Directors of Investment Companies

AGENCY: Securities and Exchange Commission

ACTION: Proposed rule

SUMMARY: The Commission is publishing for comment proposed amendments to certain exemptive rules under the Investment Company Act of 1940 to require that, for investment companies that rely on those rules: independent directors constitute at least a majority of their board of directors; independent directors select and nominate other independent directors; and any legal counsel for the independent directors be an independent legal counsel. We also are proposing amendments to our rules and forms to improve the disclosure that investment companies provide about their directors. These proposed amendments are designed to enhance the independence and effectiveness of boards of directors of investment companies and to better enable investors to assess the independence of directors.

DATES: Comments must be received on or before January 28, 2000.

ADDRESSES: Comments should be submitted in triplicate to Jonathan G. Katz, Secretary, Securities and Exchange Commission, 450 5th Street, N.W., Washington, D.C. 20549-0609. Comments also may be submitted electronically at the following E-mail address: rule-comments@sec.gov. All comment letters should refer to File No. S7-23-99; this file number should be included on the subject line if E-mail is used. Comment letters will be available for public inspection and copying in the Commission's Public Reference Room, 450 5th Street, N.W., Washington, D.C. 20549. Electronically submitted comment letters also will be posted on the Commission's Internet web site (http://www.sec.gov).

FOR FURTHER INFORMATION CONTACT: For information regarding the proposed substantive rule amendments, contact Jennifer B. McHugh, Attorney, Office of Regulatory Policy, (202) 942-0690, or regarding the disclosure amendments, contact Annette M. Capretta, Senior Counsel, or Heather A. Seidel, Senior Counsel, Office of Disclosure Regulation, (202) 942-0721, at the Division of Investment Management, Securities and Exchange Commission, 450 5th Street, N.W., Washington, D.C. 20549-0506.

SUPPLEMENTARY INFORMATION: The Securities and Exchange Commission (the "Commission") today is proposing for public comment new rules 2a19-3 [17 CFR 270.2a19-3], 10e-1 [17 CFR 270.10e-1], and 32a-4 [17 CFR 270.32a-4] and amendments to rules 0-1 [17 CFR 270.0-1], 2a19-1 [17 CFR 270.2a19-1], 10f-3 [17 CFR 270.10f-3], 12b-1 [17 CFR 270.12b-1], 15a-4 [17 CFR 270.15a-4], 17a-7 [17 CFR 270.17a-7], 17a-8 [17 CFR 270.17a-8], 17d-1 [17 CFR 270.17d-1], 17e-1 [17 CFR 270.17e-1], 17g-1 [17 CFR 270.17g-1], 18f-3 [17 CFR 270.18f-3], 23c-3 [17 CFR 270.23c-3], 30d-1 [17 CFR 270.30d-1], 30d-2 [17 CFR 270.30d-2], and 31a-2 [17 CFR 270.31a-2] under the Investment Company Act of 1940 [15 U.S.C. 80a] ("Investment Company Act" or "Act"); amendments to Forms N-1A [17 CFR 274.11A], N-2 [17 CFR 274.11a-1], and N-3 [17 CFR 274.11b] under the Investment Company Act and the Securities Act of 1933 [15 U.S.C. 77a-aa] ("Securities Act"); and amendments to Schedule 14A [17 CFR 240.14a-101] under the Securities Exchange Act of 1934 [15 U.S.C. 78a-mm] ("Exchange Act").

EXECUTIVE SUMMARY

The board of directors of an investment company ("fund") has significant responsibilities to protect investors under state law, the Investment Company Act, and many of our exemptive rules. Independent directors, in particular, serve as "independent watchdogs," guarding investor interests. These interests are paramount, for it is investors who own the funds and for whose benefit they must be operated.

We recently hosted a Roundtable on the Role of Independent Investment Company Directors, which highlighted the significance of those directors in protecting the interests of fund shareholders. After reviewing corporate governance issues and the recommendations of participants at our Roundtable, we are proposing a number of rule and form changes to enhance the independence and effectiveness of fund boards of directors and provide investors with greater information about fund directors.

First, we are proposing to require that, for funds relying on certain exemptive rules:

• independent directors constitute either a majority or a super-majority (two-thirds) of the fund's board of directors;

• independent directors select and nominate other independent directors; and

• any legal counsel for the fund's independent directors be an independent legal counsel.

  Second, we are proposing rules and rule amendments that would:

• prevent qualified individuals from being unnecessarily disqualified from serving as independent directors;

• protect independent directors from the costs of legal disputes with fund management;

• permit us to monitor the independence of directors by requiring funds to keep records of their assessments of director independence;

• temporarily suspend the independent director minimum percentage requirements if a fund falls below a required percentage due to an independent director's death or resignation; and

• exempt funds from the requirement that shareholders ratify or reject the directors' selection of an independent public accountant, if the fund establishes an audit committee composed entirely of independent directors.

Finally, we are proposing to require funds to provide better information about directors, including:

• basic information about the identity and business experience of directors;

• fund shares owned by directors;

• information about directors' potential conflicts of interest; and

• the board's role in governing the fund's operations.

In addition, today we are publishing a companion release that sets forth the views of the Commission and the Commission's staff on a number of interpretive matters. ¹ This release provides guidance on certain discrete issues related to independent directors.

Together, these initiatives are designed to reaffirm the important role that independent directors play in protecting fund investors, strengthen their hand in dealing with fund management, reinforce their independence, and provide investors with greater information to assess the directors' independence.

I. BACKGROUND

Today, millions of Americans rely on mutual funds to save and invest for their families' futures. ² More than 77 million individual investors own shares of mutual funds, which hold over $5.5 trillion in assets -- an increase of over 580 percent from ten years ago. ³ Investments in mutual funds are a significant part of retirement plans and college savings plans, as well as many traditional brokerage accounts. ⁴ Money market funds, which alone have over $1 trillion in assets, ⁵ often serve as a substitute for checking accounts and provide an important vehicle for cash management for individual investors as well as many institutions and businesses. ⁶ International and global funds give investors easy access to foreign markets. ⁷

Mutual funds are formed as corporations or business trusts under state law and, like other corporations and trusts, must be operated for the benefit of their shareholders. ⁸ Mutual funds are unique, however, in that they are "organized and operated by people whose primary loyalty and pecuniary interest lie outside the enterprise." ⁹ As described below, this "external management" of virtually all mutual funds presents inherent conflicts of interest and potential for abuses.

An investment adviser typically organizes a mutual fund and is responsible for its day-to-day operations. The adviser generally provides the seed money, officers, employees, and office space, and usually selects the initial board of directors. In many cases, the investment adviser sponsors several funds that share administrative and distribution systems as part of a "family of funds." As a result of this extensive involvement, and the general absence of shareholder activism, investment advisers typically dominate the funds they advise. ¹⁰

Investment advisers to mutual funds are generally organized as corporations, which have their own shareholders. These shareholders may have an interest in the mutual fund that is quite different from the interests of the fund's shareholders. For example, while fund shareholders ordinarily prefer lower fees (to achieve greater returns), shareholders of the fund's investment adviser might want to maximize profits through higher fees. And while fund shareholders might prefer that advisers use brokers that charge the lowest possible commissions, advisers might prefer to use brokers that are affiliates of the adviser. These types of conflicts (and others) resulted in the pervasive abuses that led Congress in 1940 to enact legislation regulating the activities of mutual funds. ¹¹

The Investment Company Act establishes a comprehensive regulatory scheme designed to protect fund investors by addressing the conflicts of interest between funds and their investment advisers or other affiliated persons. The Act strictly regulates some of the most serious conflicts. For example, the Act prohibits certain transactions between a fund and its affiliates, including the investment adviser, unless approved by the Commission. ¹² The Act also relies on fund boards of directors to police conflicts of interest.

Under state law, directors are generally responsible for the oversight of all of the operations of a mutual fund. ¹³ In addition, the Investment Company Act assigns many specific responsibilities to fund boards. For example, fund boards must evaluate and approve a fund's advisory contract and any assignment of the contract, and may unilaterally terminate the contract. ¹⁴ Directors also approve the fund's principal underwriting contract, ¹⁵ select the fund's independent accountant, ¹⁶ and value certain securities held by the fund. ¹⁷ In addition, under the Act and our rules, directors have responsibility for evaluating the reasonableness of advisory and distribution-related fees charged the fund ¹⁸ and managing certain operational conflicts. Just recently, for example, we clarified that boards must assume oversight responsibility for personal securities transactions by employees of the fund and its adviser. ¹⁹

The Act requires that independent directors constitute at least 40 percent of a fund's board, ²⁰ and sets the standards for when a person will be disqualified from being an independent director (i.e., will be considered an "interested person" under the Act). ²¹ These independent directors play an important role in representing and guarding the interests of investors. As has been stated many times, Congress intended these directors to be the "independent watchdogs" ²² for investors and to "supply an independent check on management." ²³

Many requirements of the Act and our rules that protect investors from conflicts of interest specifically rely on action by these independent directors. The Act, for example, requires independent directors to separately evaluate and approve the fund's contract with an investment adviser or principal underwriter. ²⁴ Our rules have permitted innovative types of funds, more efficient fund operations, and new distribution arrangements by exempting funds from prohibitions related to conflicts of interest. While these rules have provided important flexibility to allow mutual funds to meet the changing needs of investors, they also rely on approval, oversight, and monitoring by independent directors to protect investors. ²⁵

Earlier this year we held a two-day public Roundtable discussion on the role of independent directors of mutual funds. ²⁶ Participants in the Roundtable included independent directors, investor advocates, executives of fund advisers, academics, corporate governance experts, and experienced legal counsel. They examined the activities and responsibilities of independent directors and reviewed the nature of their independence. Participants also discussed various ways that the Commission might promote greater effectiveness of independent directors.

We endorse the sentiments of the Roundtable participants who favor enhancing the effectiveness and independence of fund boards of directors. While those sentiments can be fully achieved only through amendments to the Investment Company Act, we are impressed by the consensus of the participants concerning the importance of the role of independent directors and the conditions they believe are necessary to enhance the effectiveness of those directors. We therefore are proposing rule amendments designed to reaffirm the important role that independent directors play in protecting fund investors, strengthen their hand in dealing with fund management, reinforce their independence, and provide investors with better information to assess the independence of directors.

II. DISCUSSION

A. Enhancing the Independence of Fund Boards of Directors

Panelists at our recent Roundtable discussed a number of possible ways to enhance the independence and effectiveness of fund boards. Most participants agreed that independent directors can best fulfill their responsibilities when they constitute a substantial majority of the board. Participants also recommended that the selection of new independent directors be entrusted to existing independent directors and that independent directors have independent legal counsel. ²⁷ An industry advisory group organized by the Investment Company Institute recently made similar recommendations in a "best practices" report ("ICI Advisory Group Report"). ²⁸

The recommendations of the Roundtable participants have led us to review our exemptive rules that provide funds and advisers relief from various statutory prohibitions designed to prevent the most egregious conflicts of interest. Roundtable participants repeatedly noted that one of the most important functions of independent directors is to oversee conflicts of interest. ²⁹ Although the rules that we have adopted over the years have expanded the responsibilities of boards, the rules generally do not contain conditions designed to enhance the independence and effectiveness of fund boards, with two notable exceptions. ³⁰

Upon reflection, and in light of the recommendations of the Roundtable participants, we believe that our exemptive rules that rely on fund boards to approve and oversee arrangements or transactions that involve conflicts of interest and are otherwise prohibited by the Act also should contain provisions designed to enhance director independence and effectiveness. We therefore are proposing amendments to certain exemptive rules under the Investment Company Act to enhance the independence of fund directors who are charged with overseeing the fund's activities and transactions covered by those rules. These amendments would require, for funds that rely (or whose affiliated persons rely) on the rules, that: (i) independent directors constitute either a majority or a super-majority (two-thirds) of their boards; (ii) independent directors select and nominate other independent directors; and (iii) any legal counsel for the independent directors be an independent legal counsel.

Our proposals to enhance board independence would amend ten rules under the Investment Company Act. We have selected those rules that (i) exempt funds or their affiliated persons from provisions of the Act, and (ii) have as a condition the approval or oversight of independent directors. For convenience, we will refer to these rules as the "Exemptive Rules." ³¹ The Exemptive Rules typically relieve funds from statutory prohibitions that preclude certain types of transactions or arrangements that would involve serious conflicts of interest. ³² In one case, a rule permits the board to approve an interim advisory agreement without a shareholder vote that otherwise would be required. ³³ Based on these criteria, we propose to amend the following rules:

• Rule 10f-3 (permitting funds to purchase securities in a primary offering when an affiliated broker-dealer is a member of the underwriting syndicate);

• Rule 12b-1 (permitting use of fund assets to pay distribution expenses);

• Rule 15a-4 (permitting fund boards to approve interim advisory contracts without shareholder approval);

• Rule 17a-7 (permitting securities transactions between a fund and another client of the fund's adviser);

• Rule 17a-8 (permitting mergers between certain affiliated funds);

• Rule 17d-1(d)(7) (permitting funds and their affiliates to purchase joint liability insurance policies);

• Rule 17e-1 (specifying conditions under which funds may pay commissions to affiliated brokers in connection with the sale of securities on an exchange);

• Rule 17g-1(j) (permitting funds to maintain joint insured bonds);

• Rule 18f-3 (permitting funds to issue multiple classes of voting stock); and

• Rule 23c-3 (permitting the operation of interval funds by enabling closed-end funds to repurchase their shares from investors).

The Commission requests comment on the criteria that we have used to select these rules. Are there additional rules that we should similarly amend? Conversely, should any of the Exemptive Rules not be amended?

Although the Commission urges all funds to adopt these measures to strengthen the independence of their boards, we are not proposing to require all funds to adopt these measures. Funds that do not rely on any of the Exemptive Rules will not be subject to these requirements. They may continue, for example, to have only 40 percent of their boards consist of independent directors.

As discussed above, an advisory group organized by the Investment Company Institute ("ICI Advisory Group") has issued a report containing a set of "best practices" for "enhancing a culture of independence and effectiveness" of fund directors. ³⁴ These best practices generally include some of the practices that our proposed rule amendments would require boards to adopt in order to rely on the Exemptive Rules. We applaud the initiative, but, as the report acknowledges, many of the "best practices" may be impracticable or unnecessary for all funds to adopt. Moreover, it may not be appropriate for us to address many of the recommendations through rulemaking. ³⁵ Thus, we are not at this time proposing to require that funds relying on the Exemptive Rules follow all of these practices. Nonetheless, we believe that fund boards should give serious consideration to the recommendations of the ICI Advisory Group. We request comment whether we should amend the Exemptive Rules, or other rules, to require funds relying on them to follow any of these "best practices." Commenters who favor any of these practices also should address the benefits and burdens of amending the Exemptive Rules in this manner.

1. Independent Directors as a Majority of the Board

a) Proposed Board Composition Requirements

We believe that a fund board that has at least a majority of independent directors is better equipped to perform its responsibilities of monitoring potential conflicts of interests and protecting the fund and its shareholders. ³⁶ By virtue of its independence, and its ability to act without the approval of the investment adviser (whose employees often serve as interested, or "inside," directors on fund boards), such a board is better able to exert a strong and independent influence over fund management. ³⁷ This is particularly important in circumstances where the fund's interests conflict with those of the adviser. ³⁸

Today most, but not all, mutual funds have boards with at least a simple majority of independent directors . ³⁹ When our Division of Investment Management studied mutual fund governance in 1992 it recommended that, as a requirement for all funds, independent directors constitute at least a majority of a fund's board. ⁴⁰ Many of the Roundtable participants stated that, based on their experience, a fund board generally is more effective if independent directors represent a substantial majority of the board. ⁴¹ Similarly, the ICI Advisory Group Report recently endorsed boards having a "super-majority" of independent directors. The Report concluded that a two-thirds majority of independent directors on a board "will be more effective than a simple majority in enhancing the authority of independent directors." ⁴²

We take the conclusions of the ICI Report as a serious recommendation reflecting the collective experience and wisdom of the Advisory Group, which consisted of prominent members of the mutual fund industry. ⁴³ Although the Report did not address whether Congress or the Commission should adopt a two-thirds majority as a regulatory requirement, it recommended the standard as a "best practice" for all funds to consider. ⁴⁴ It is unclear, however, why a super-majority standard as a "best practice" would be appropriate for some fund boards and not others.

A simple majority requirement would permit, under state law, the independent directors to control the "corporate machinery," i.e., to elect officers of the fund, call meetings, solicit proxies, and take other actions without the consent of the adviser. Such a provision would require few funds to change the current composition of their boards, but would bring those that must change into conformity with the better practice. A two-thirds requirement, on the other hand, could change the dynamics of board decision-making in favor of the interests of investors, but may require many funds to change the composition of their boards.

In light of the potential benefits to funds, their boards, and shareholders, we are proposing to amend the Exemptive Rules to require funds relying on them to have boards with at least a majority of independent directors. Comment is requested on whether we should adopt a simple majority requirement, as the staff recommended in 1992, or the two-thirds super-majority requirement recommended by the ICI Advisory Group Report. We also request comment whether we should adopt an even higher percentage requirement (e.g., 75 percent or 100 percent). ⁴⁵

We note that the charters ⁴⁶ of some funds may contain provisions that require the approval of greater than a majority of a fund's board for some matters, and, in light of our proposed amendments, other funds may amend their charters to provide that a board may act only upon the vote of greater than a simple (or two-thirds) majority of its members. Would the existence of these super-majority voting provisions in fund charters undercut the effectiveness of a board with a majority of independent directors by requiring the consent of the "inside" directors and thus, in many cases, give the adviser a veto over board votes? We request comment regarding the prevalence and potential effect of these voting provisions in fund charters.

If we adopt the proposed amendments, we expect to delay the compliance date for one year to allow funds to bring their boards into compliance with the majority independence condition to the Exemptive Rules. ⁴⁷ As of the compliance date, any fund relying on an Exemptive Rule would be required to have a board with the requisite percentage of independent directors. We request comment on this transition period.

b) Suspension of Board Composition Requirements

If the death, disqualification, or bona fide resignation of an independent director causes the representation of independent directors on the board to fall below that required under the Investment Company Act, section 10(e) of the Act suspends the percentage requirement for a short time to allow the vacancy to be filled. ⁴⁸ Under section 10(e), the relevant percentage requirement is suspended for 30 days if the board may fill the vacancy, ⁴⁹ or for 60 days if the vacancy must be filled by a shareholder vote. ⁵⁰ Section 10(e) also authorizes the Commission to set a longer period for filling a board vacancy in these circumstances. ⁵¹

In our experience, the time provided by section 10(e) is insufficient for most funds to select and nominate qualified independent director candidates, and, if necessary, hold a shareholder election. Many funds address this problem by avoiding the need to rely on the section -- they have a greater percentage of independent directors than is required by the Act. This approach may become more difficult if, as we propose, funds relying on the Exemptive Rules must have a majority or a super-majority of independent directors. ⁵² Moreover, the consequence of a fund falling below the minimum required percentage of independent directors would be more severe and more immediate because the fund would lose the availability of the Exemptive Rules. ⁵³

The Commission is proposing new rule 10e-1 to address these concerns. Proposed rule 10e-1 would suspend the board composition requirements of the Act, and of the rules under the Act, for 60 days if the board of directors may fill the vacancy or 150 days if a shareholder vote is required. ⁵⁴ We believe these longer time periods are appropriate in light of the need to select, nominate, and elect qualified candidates for service as independent directors. ⁵⁵

We request comment whether the proposed 60-day and 150-day periods are adequate to provide funds and their independent directors with the time needed to approve new independent directors. Commenters who believe that a longer or shorter period is appropriate should explain why, and specify the number of days they believe would be adequate.

2. Selection and Nomination of Independent Directors

Independent directors who are truly independent are more effective in their roles as "watchdogs" for fund shareholders. While the Investment Company Act precludes independent directors from having certain affiliations or relationships with the fund's adviser or principal underwriter, ⁵⁶ no law can guarantee that an independent director will be vigilant in protecting fund shareholders. Fund shareholders therefore must depend on the character, ability, and diligence of persons who serve as fund directors to protect their interests. ⁵⁷

One recognized method of enhancing the independence of directors is to commit the selection and nomination of new independent directors to the incumbent independent directors. ⁵⁸ Independent directors who are selected and nominated by other independent directors, rather than by the fund's adviser, are more likely to have their primary loyalty to shareholders rather than the adviser. ⁵⁹ In addition, when independent directors are self-selecting and self-nominating, they are less likely to feel beholden to the adviser. Thus, they may be more willing to challenge the adviser's recommendations when the adviser's interests conflict with those of the shareholders. ⁶⁰

Two comprehensive studies that addressed mutual fund governance recognized that the selection and nomination of independent directors by other independent directors could enhance their independence. ⁶¹ In its guidebook for fund directors, the American Bar Association's Section of Business Law has endorsed this practice, ⁶² as did several participants at our Roundtable. ⁶³ The recent ICI Advisory Group report also recommended the self-selection and self-nomination of independent directors. ⁶⁴ As noted above, two of our rules currently require funds to have self-selecting and self-nominating independent directors, ⁶⁵ and many fund groups have adopted this practice. ⁶⁶

We are proposing to amend each of the Exemptive Rules to require that funds relying on those rules have boards whose independent directors select and nominate any other independent directors. ⁶⁷ Funds that have adopted distribution plans under rule 12b-1, which already contains this requirement, would be unaffected by the proposal. ⁶⁸ Funds whose independent directors were not nominated in this manner would not immediately lose their ability to rely on the Exemptive Rules. Rather, if we adopt the proposed amendments, these funds would be required to adopt the practice before the compliance date for the amendments, and the fund's incumbent independent directors subsequently would select and nominate all independent directors of the fund. ⁶⁹

We understand that committing the selection and nomination of independent directors to a board committee composed entirely of independent directors might, in some cases, conflict with applicable state law. ⁷⁰ We believe that a fund could comply with our proposed amendments in those circumstances if the fund's independent directors choose the candidates and then present their recommendations to the full board. We request comment whether this approach adequately addresses any potential conflicts between state law and our proposed amendments regarding self-selection and self-nomination of independent directors.

Moreover, our proposals regarding the self-selection and self-nomination of independent directors are not intended to limit the abilities of public shareholders to nominate independent directors. To the extent permitted under state law, shareholders may participate in the nomination process. ⁷¹

We request comment whether we should further amend the Exemptive Rules to require that independent directors, rather than the entire board, elect other independent directors in those instances when a shareholder vote is not required. ⁷² Commenters should discuss the effect state law would have on a fund board's ability to delegate its authority to elect directors to a subset of the board.

3. Independent Legal Counsel

Another recognized method of enhancing the independence and effectiveness of independent directors is to provide them with independent counsel. ⁷³ Because mutual funds are highly regulated and their boards frequently are called upon to protect fund shareholders from conflicts of interest, independent counsel can be particularly helpful to independent directors of funds. ⁷⁴ Experienced counsel can help to identify potential conflicts of interest and other compliance issues. They can assist directors in "marshal[ling] arguments to balance those presented by management in matters involving conflicts of interest," and evaluating legal issues with an independent and critical eye. ⁷⁵ Often, independent counsel can draw on their experience and knowledge to identify best practices of other funds that might be appropriate for directors to adopt for their fund.

We believe counsel who does not also represent the fund's adviser can best provide zealous representation of independent directors. Several of our Roundtable participants made this point, ⁷⁶ as have many legal commentators over the years. ⁷⁷ The recent ICI Advisory Group Report recommended that independent directors have qualified counsel who is independent from the fund's adviser and other service providers. ⁷⁸ Courts too have recognized that independent legal counsel improves the deliberative process of fund independent directors. ⁷⁹ As a result, independent directors of many funds retain legal counsel who does not also represent the adviser and, in some cases, does not represent the fund.

We are aware, however, that in some cases counsel has regularly represented the fund, the fund's adviser, and the independent directors. We have no doubt that such representation has been in conformity with applicable codes of legal ethics, which permit a lawyer to represent clients with conflicting interests after full disclosure and client consent. ⁸⁰ We nevertheless are troubled by such conflicts and how they affect the ability of independent directors to carry out their responsibilities under the Act and the Exemptive Rules. We are particularly concerned when lawyers represent both the independent directors and management organizations in the negotiation of the advisory contract, distribution arrangements (e.g., 12b-1 plans), and other matters of fundamental importance to a fund and its shareholders. Lawyers representing fund management may not suggest courses of action to independent directors that are opposed by their management clients. Thus, we are proposing to amend the Exemptive Rules to require that counsel for a fund's independent directors not also act as counsel to the fund's adviser, principal underwriter, or administrator (or their control persons). ⁸¹

We are not, however, proposing at this time to require independent directors to retain legal counsel. Although we believe that independent directors are in the best position to fulfill the roles assigned to them by the Exemptive Rules if they have the assistance of independent counsel, the services of counsel do not come without cost. ⁸² We are hesitant to propose a rule that might result in the engagement of legal counsel simply to fulfill a legal requirement. Moreover, we believe that a likely result of our proposed amendments would be that fund directors will seek independent counsel. Comment is requested whether we should amend the Exemptive Rules to require independent directors of funds relying on those rules to retain independent legal counsel. Would this requirement impose substantial costs on small fund groups? If we adopt this condition to the Exemptive Rules, should we provide for an exception for smaller fund groups? If so, what factors should determine which fund groups are small?

Under the proposed amendments, reliance on each of the Exemptive Rules would be conditioned on any legal counsel for a fund's independent directors being an "independent legal counsel." ⁸³ A person would be an "independent legal counsel" if the fund reasonably believes the person and his law firm, partners, and associates ⁸⁴ have not acted as legal counsel for the fund's investment adviser, principal underwriter, administrator ⁸⁵ (collectively, "management organizations"), or any of their control persons ⁸⁶ at any time since the beginning of the fund's last two completed fiscal years. ⁸⁷ The independent directors could make an exception and permit a person to serve as independent legal counsel even if the person has a remote or minor conflict of interest because the person has provided legal advice to management organizations or their control persons. ⁸⁸

(a) Independent of Fund Management Organizations. The proposed amendments would treat as fund management organizations, fund advisers (including sub-advisers), principal underwriters, and fund administrators. ⁸⁹ We are proposing to include fund administrators because, in some fund complexes, an administrator performs many of the management functions traditionally performed by a fund's adviser, and thus may have the same types of conflicts as an investment adviser sponsoring a fund. ⁹⁰ The limitations on dual representation also would extend to control persons of fund management organizations: persons who directly or indirectly control, are controlled by, or are under common control with the adviser, principal underwriter, or fund administrator. ⁹¹ Counsel to both a parent company of the fund's adviser and a fund's independent directors, for example, may face the same conflicts as those faced by counsel to the fund's adviser and the fund's independent directors. ⁹² We request comment whether the amendments should extend to other types of service providers in addition to management organizations, ⁹³ and to persons other than control persons (e.g., affiliated persons of a management organization).

Under the proposed amendments, a person could be an independent legal counsel to a fund's independent directors regardless of the nature and amount of legal services he or she provides to the fund itself. A person acting as both fund counsel and independent director counsel ordinarily should not have the types of conflicts of interest that would diminish the counsel's ability to provide zealous representation of independent directors. ⁹⁴ Similarly, our proposal would not preclude counsel from representing the independent directors of multiple funds affiliated with the same management organization. We request comment on this provision.

(b) Two-Year Period. Section 2(a)(19) of the Act prevents any person who has acted as legal counsel to a fund's adviser or principal underwriter during the last two years from serving as an independent director of the fund. ⁹⁵ This section reflects Congress's belief that acting as counsel to fund management organizations creates conflicts that may affect a person's ability to represent shareholder interests. Based upon similar considerations, the proposed amendments would (subject to the exception discussed below) preclude a person from acting as counsel for independent directors for two years after having acted as legal counsel to a fund management organization or its control person. As in section 2(a)(19), the disqualification would apply to any partner or employee of a person who acted as legal counsel to the management organization or its control person. ⁹⁶

(c) Reasonable Belief. The proposed amendments would require the fund to have a "reasonable belief" that counsel to the independent directors meets the requirements of the independent legal counsel definition. If, despite the fund's reasonable belief, counsel does not actually meet the requirements, the fund would not lose the ability to rely on any of the Exemptive Rules. A fund could form a reasonable belief based on a representation from counsel. If the fund relies on counsel's representation, the fund also should obtain an undertaking that the counsel will inform the fund and the independent directors if it begins to act as legal counsel to the fund management organizations or any of their control persons.

(d) Exception. As discussed above, these proposed amendments are intended to assure that independent directors have the benefit of counsel who is free from the types of conflicts that may affect the advice provided to independent directors. The scope of the proposed limitation, described above, is broad and covers direct and indirect conflicts. As a result, the proposed amendments might preclude a person from serving as counsel to a fund's independent directors because of a remote or minor conflict involving, for example, a law-firm partner who represented an affiliate of the fund's adviser in a minor real estate transaction. Therefore, the proposed definition of "independent legal counsel" includes an exception that would permit the independent directors to retain the counsel if they determine that the counsel's representation was "so limited that it would not adversely affect the counsel's ability to provide impartial, objective, and unbiased legal counsel to the [independent] directors." ⁹⁷

The exception would not permit waivers in all instances, but only in circumstances where the nature or extent of the conflict is minor. We would expect that the independent directors, in making a determination under the exception, would consider all relevant factors. These factors could include whether the representation presented a direct and ongoing conflict with the fund, the amount of legal fees generated by the representation, and the nature and the extent of the affiliation between a control person and a fund management organization. The basis for any determination under this provision also must be recorded in board meeting minutes. ⁹⁸

We request comment on the approach we have taken. Should independent directors who engage legal counsel under the exception to the general rule be required to make findings different from those proposed? For example, the Blue Ribbon Committee on Improving the Effectiveness of Corporate Audit Committees recommended that a director who does not meet proposed independence standards be allowed to serve as a member of a company's audit committee if the board, under exceptional and limited circumstances, determines that membership on the committee is required by the best interests of the company and its shareholders, and the board discloses, in the next annual proxy statement, the reasons why the director does not meet the independence standards and the reasons for the board's determination. ⁹⁹ Should we also require public disclosure of the independent directors' determination regarding their counsel's conflict and the nature of that conflict? If so, in what document should the disclosure be made?

(e) Transition Period. If we adopt the proposals after the comment period, counsel for the independent directors of funds relying on any of the Exemptive Rules would not be required to be "independent legal counsel" until the compliance date established in the adopting release. We believe that independent directors of most fund groups would not be required to seek new counsel. In some cases, however, they may. Comment is requested on the transition time that independent directors would need to hire new counsel.

B. Limits on Coverage of Directors Under Joint Insurance Policies

The oversight responsibilities that the Act assigns to independent directors ¹⁰⁰ may create tensions between those directors and the fund's adviser ¹⁰¹ that can lead to disputes. ¹⁰² A dispute among these parties that escalates to the level of a lawsuit can result in significant legal expenses for the independent directors. ¹⁰³

Funds typically purchase "errors and omissions" insurance policies ("D&O/E&O policies") ¹⁰⁴ to cover expenses incurred by directors and officers in the event of litigation. ¹⁰⁵ Often these policies are joint policies that cover numerous funds within a fund family as well as the adviser and principal underwriter of those funds. Although the Investment Company Act and our rules generally prohibit joint transactions and other joint arrangements involving a fund and its affiliates, ¹⁰⁶ rule 17d-1(d)(7) permits the purchase of joint D&O/E&O policies. ¹⁰⁷

Joint D&O/E&O policies historically have excluded claims in which the parties under the policy sue each other. ¹⁰⁸ A policy that insures both a fund's investment adviser and its independent directors therefore may not cover the independent directors' expenses of litigation with the fund's adviser. Without this coverage, independent directors face substantial personal legal expenses in the event of a lawsuit. ¹⁰⁹

The exclusion of coverage under joint policies creates a potential threat to directors' personal assets, which can hamper directors' willingness to question management and weaken their resolve to protect fund shareholders in the event of a conflict with the adviser. Because we are concerned about the effect that these exclusions may have on the ability of independent directors to carry out their statutory responsibilities, we propose to amend rule 17d-1(d)(7) to make the rule available only for joint liability insurance policies that do not exclude coverage for litigation between the independent directors and the fund's adviser. ¹¹⁰ These proposals are intended to allow independent directors to engage in the good faith performance of their statutory responsibilities without concern for their personal financial security. ¹¹¹

We request comment on the proposed amendments to rule 17d-1(d)(7) concerning the purchase of joint D&O/E&O policies. The ICI Advisory Group Report recommended more broadly that fund boards should consider obtaining D&O/E&O insurance policies and/or indemnification from the fund "that is adequate to ensure the independence and effectiveness of independent directors." ¹¹² The proposed amendments do not require that funds obtain insurance coverage or indemnification for independent directors, so that funds will have the latitude to determine which arrangements are appropriate for their circumstances. We request comment whether we should further amend rule 17d-1(d)(7) to require that joint insurance polices purchased under the rule be in an amount adequate to ensure that independent directors can perform their duties in an independent and effective manner, and what that amount might be.

C. Exemption from Ratification of Independent Public Accountant Requirement for Funds with Independent Audit Committees

The Investment Company Act requires that a fund's independent directors select the fund's independent public accountant. ¹¹³ The Act further requires that the selection of the fund's independent public accountant be submitted to shareholders for ratification or rejection at their next annual meeting. ¹¹⁴

We have observed that shareholders rarely contest votes over the ratification of the selection of a fund's independent accountant. Many believe shareholder ratification has become perfunctory. This may have occurred because of the growth of funds, ¹¹⁵ their organization into large complexes, the increased complexity of accounting issues, or the consolidation of accounting firms, which have made it impracticable for shareholders to evaluate the qualifications and independence of fund auditors. We are proposing, therefore, to exempt funds from the shareholder ratification requirement if the auditor is subject to the oversight and direction of an audit committee consisting entirely of independent directors.

Today, in many corporations and fund complexes, audit committees play an important and growing role in assuring the integrity of financial statements. ¹¹⁶ The current listing requirements of the primary U.S. securities exchanges require publicly traded companies to have audit committees, ¹¹⁷ and many commentators have recognized the value of independent audit committees and the significance of their function in a corporate governance structure. ¹¹⁸ Recently, the Blue Ribbon Committee on Improving the Effectiveness of Corporate Audit Committees emphasized the important role of audit committees and recommended enhanced responsibilities, membership standards, and methods of operation designed to strengthen their oversight function. ¹¹⁹ The ICI Advisory Group Report, furthermore, recommended that fund boards establish audit committees comprised entirely of independent directors. ¹²⁰

We believe that the ongoing oversight provided by an independent audit committee can provide greater protection to shareholders than the current requirement for shareholder ratification of a fund's independent auditors. We therefore are proposing a rule that would exempt a fund from the Act's requirement that shareholders ratify or reject the selection of the fund's independent public accountant if the fund has an audit committee comprised wholly of independent directors. ¹²¹ In order for a fund to rely on the proposed exemption, (i) the audit committee must be responsible for overseeing the fund's accounting and auditing processes, ¹²² (ii) the fund's board of directors must adopt an audit committee charter setting forth the committee's structure, duties, powers, and methods of operation, ¹²³ and (iii) the fund must maintain of a copy of the charter. ¹²⁴

We request comment regarding the conditions of the proposed rule. Should the exemption require that the charter set forth certain specific responsibilities and methods of operation? Should funds relying on the exemption be required to provide a copy of their audit committee charter as an exhibit to their registration statement, and should the board be required to review the charter on an annual basis? Should the exemption require fund audit committees to obtain an annual representation from the fund's independent public accountant certifying its independence, as the ICI Advisory Group suggested? ¹²⁵ Should the exemption include other conditions that are similar to the recommendations of the ICI Advisory Group and Blue Ribbon Committee on Improving the Effectiveness of Corporate Audit Committees?

The proposed rule assumes that the appropriate form for the instrument governing an audit committee is a charter. Should the rule explicitly recognize that the audit committee provisions could be included in a document other than the charter, such as the fund's by-laws, articles of incorporation, or declaration of trust?

D. Qualification as an Independent Director

In addition to the amendments to enhance the independence of fund boards, we are proposing amendments to prevent qualified individuals from being unnecessarily disqualified from serving as independent directors. The Investment Company Act sets standards for who may be considered an independent director. ¹²⁶ While these standards are meant to exclude individuals with affiliations or business interests that can impair their independence, there are circumstances in which the standards may cause certain individuals to be unnecessarily disqualified from serving as an independent director. For this reason, Congress directed the Commission to apply the standards "in a flexible manner" and adopt appropriate exemptions. ¹²⁷ Today we are proposing (i) to amend the rule that permits directors to be considered independent directors even if they are affiliated with a broker-dealer, and (ii) a new rule that would prevent directors from being disqualified as independent directors solely because they own shares of index funds that hold limited interests in their fund's adviser or principal underwriter.

1. Affiliation with a Broker-Dealer

Section 2(a)(19) of the Act provides that no person can be an independent director if he is, or is affiliated with, a registered broker-dealer. ¹²⁸ This provision is designed to prevent independent directors from being influenced by a business relationship with broker-dealers. ¹²⁹ Rule 2a19-1 under the Act provides relief from this provision under certain conditions, but only if no more than a minority of a fund's independent directors are broker-dealers or affiliated with broker-dealers. ¹³⁰ 0When we proposed this condition in 1984, we explained that allowing all of the fund's independent directors to be affiliated with broker-dealers would be inconsistent with Congress's intent to separate independent directors from the brokerage industry. ¹³¹

In recent years, some directors have been unable to qualify as independent directors due to the condition that no more than a minority of a fund's independent directors may be affiliated with a broker-dealer. This condition has been especially troublesome for funds with small boards of directors. For example, if a three-member board has only two independent directors, neither director can rely on rule 2a19-1 because it would result in more than a minority of the independent directors relying on the rule. In these types of circumstances, the Commission has granted exemptions from this condition of the rule. ¹³²

We are proposing to amend rule 2a19-1 to provide that no more than one-half of a fund's independent directors may be broker-dealers or their affiliates. ¹³³ This condition should make the rule more flexible for funds with small boards of directors, while continuing to ensure that not all of a fund's independent directors are broker-dealers or their affiliates. ¹³⁴ We seek comment on whether rule 2a19-1 should be expanded further.

2. Ownership of Index Fund Securities

Section 2(a)(19) disqualifies an individual from being considered an independent director if he knowingly has any direct or indirect beneficial interest in a security issued by the fund's investment adviser or principal underwriter, or by a controlling person of the adviser or underwriter. ¹³⁵ A fund director, for example, who owns securities issued by the fund's adviser (or its parent company) could not be an independent director. This provision was designed to ensure that an independent director does not have a financial interest in the organizations that are closely associated with the fund or that would benefit from payments that the independent director is charged with scrutinizing. ¹³⁶

If a director owns securities of an index fund ¹³⁷ that seeks to replicate a securities market index that includes securities of the fund's adviser (or principal underwriter or a controlling person of the adviser or principal underwriter), an issue could arise whether the director knowingly has an indirect beneficial interest in the securities of the adviser (or principal underwriter or controlling person). ¹³⁸ We believe that this attenuated interest in the adviser's or underwriter's securities is not the type of interest Congress intended to prohibit independent directors from owning when it adopted section 2(a)(19). An index fund's investment decision-making process is dictated by the goal of mirroring the performance of a market index, and thus is largely mechanical. ¹³⁹ Because index fund portfolios typically are spread among a large number of issuers, ownership of their shares is unlikely to have a material effect on the independent judgment of a fund director.

In order to resolve concerns that may have arisen about the status of independent directors who own index funds, we are proposing a new rule that would conditionally exempt an individual from being disqualified as an independent director merely because he owns shares of an index fund that invests in the adviser or underwriter of the fund, or their controlling persons. ¹⁴⁰ The exemption would be available if the value of securities issued by the adviser or underwriter (or controlling person) does not exceed five percent of the value of any index tracked by the index fund. ¹⁴¹ The purpose of this condition is to assure that an independent director's indirect interest in the adviser's securities will not be substantial enough to impair his independence and create a conflict of interest.

The proposed rule would define an "index fund" as a fund with an investment objective to replicate the performance of a securities index or indices. ¹⁴² We request comment on the proposed definition of index fund. Does it encompass the types of funds for which relief is appropriate? Should other types of investment vehicles be included in the proposed rule? We also request comment on the proposed limit on the percentage of the value of securities of the adviser or principal underwriter (or their controlling persons) represented in any index tracked by the fund. Should the rule allow an independent director to own index fund shares when the value of the securities issued by the adviser or underwriter (or their controlling persons) in the index constitutes more than five percent of the value of any index tracked by the fund? Should the limit be less than five percent?

E. Disclosure of Information about Fund Directors

Participants at the Roundtable agreed that independent directors can vigilantly represent the interests of mutual fund shareholders only when they are truly independent of those who operate and manage the fund. ¹⁴³ We agree with the Roundtable participants and believe that the effectiveness of fund boards of directors is enhanced by a high degree of independence of each independent director.

We believe that shareholders have a significant interest in knowing who the independent directors are, whether the independent directors' interests are aligned with shareholders' interests, whether the independent directors have any conflicts of interest, and how the directors govern the fund. This information helps a mutual fund shareholder to evaluate whether the independent directors can, in fact, act as an independent, vigorous, and effective force in overseeing fund operations.

The Commission has long recognized the importance of providing mutual fund shareholders with relevant information about fund directors and has required funds to provide shareholders with certain information about fund directors. Currently, information about directors is available in fund registration statements and proxy statements for the election of directors. Generally, funds are required to provide basic information about directors in the statement of additional information ("SAI") and proxy statements, including name and age; positions with the fund; principal occupations during the past five years; and compensation from the fund and fund complex. ¹⁴⁴ Moreover, funds are required to disclose in proxy statements for the election of directors a director's positions with, interests in, and transactions with, the fund and certain persons related to the fund. ¹⁴⁵

For some time, however, we have been concerned that mutual fund investors do not in all cases have access to significant information about fund directors when they need it. When we adopted our recent comprehensive revisions to the mutual fund prospectus, we noted that mandating more information about fund directors than is available under our existing rules may be appropriate in light of independent directors' role as "watchdogs" for fund shareholders. ¹⁴⁶ Critics have charged that shareholders do not know the very people who are entrusted with safeguarding their interests. ¹⁴⁷ Some have complained that fund shareholders do not know whether the interests of independent directors are aligned with shareholders or with fund management. ¹⁴⁸

We have reevaluated our disclosure requirements in light of these criticisms and have concluded that, while our fundamental approach is sound, there are several gaps in the information that shareholders currently receive about directors. Historically, the primary vehicle for providing information about mutual fund directors was the proxy statement prepared in connection with shareholder meetings. In recent years, the proxy statement has become an ineffective vehicle for communicating information to fund shareholders on a regular basis because funds generally are no longer required to hold annual meetings. ¹⁴⁹

In addition, although mutual funds are required to disclose certain information that bears on a director's potential conflicts, the SAI requirements and proxy rules do not require disclosure of other circumstances that could raise similar conflict of interest concerns, such as those involving a director's immediate family members. The current rules also do not require disclosure of information that may show that a director's interests are aligned with shareholder interests, including a director's securities holdings in funds in the fund complex.

Therefore, we are proposing amendments to our disclosure rules to close these gaps. Our proposals would require mutual funds to:

• Provide basic information about directors to shareholders annually so that shareholders will know the identity and experience of their representatives;

• Disclose to shareholders fund shares owned by directors to help shareholders evaluate whether directors' interests are aligned with their own;

• Disclose to shareholders information about directors that may raise conflict of interest concerns; and

• Provide information to shareholders on the board's role in governing the fund.

These proposals would supplement the information that currently is available in the mutual fund SAI and in proxy statements. For ease of reference, we have attached as Appendix A a table cross-referencing the proposed disclosure requirements in the proxy rules and the SAI of Form N-1A with existing requirements. ¹⁵⁰

1. Basic Information about Directors

a) Location of Information

The Commission is proposing to require mutual funds to disclose basic information about directors in an easy-to-read tabular format. ¹⁵¹ We are proposing to combine in one table certain information currently required for directors in the SAI and proxy statements. ¹⁵² This new table would be required in three places: the fund's annual report to shareholders, SAI, and proxy statement for the election of directors. This would ensure that the information is available to prospective investors upon request. It also would ensure that mutual fund shareholders receive basic information about the identity and experience of their directors both annually and whenever they are asked to vote to elect directors.

We are not proposing to require that basic information about directors be included in the prospectus. We considered, and rejected, this idea during our recent top-to-bottom overhaul of the mutual fund prospectus. ¹⁵³ At the time of our prospectus overhaul, however, we directed the Division of Investment Management to consider whether information about directors should be included in fund annual reports, and we have now concluded that it should. ¹⁵⁴

Our proposals would, for the first time, require that basic information about mutual fund directors be included in the annual report to shareholders. ¹⁵⁵ Because the proxy statement is no longer received by most fund shareholders annually, we are proposing to include basic information about directors in the annual report to ensure that shareholders will receive it regularly. We also are proposing to require funds to include in the annual report a statement that the SAI includes additional information about fund directors and is available without charge upon request. ¹⁵⁶ The statement must include a toll-free (or collect) telephone number for shareholders to call for additional information.

We request comment on the appropriate location for basic information about mutual fund directors. Please address whether basic information should be included in the prospectus, SAI, annual report, and/or proxy statement. Should we, for example, reconsider our decision not to include any of the basic information about directors in the prospectus?

b) Required Information

The proposed table would require for each director: (1) name, address, and age; (2) current positions held with the fund; (3) term of office and length of time served; (4) principal occupations during the past five years; (5) number of portfolios overseen within the fund complex; and (6) other directorships held outside of the fund complex. ¹⁵⁷ The table also would require for each "interested" director, as defined in section 2(a)(19) of the Act, a description of the relationship, events, or transactions by reason of which the director is an interested person. ¹⁵⁸

Currently, mutual funds must disclose the number of other registered investment companies in the fund complex that a director oversees. ¹⁵⁹ The Commission now is proposing to require disclosure of the total number of portfolios, rather than registered investment companies, that a director oversees. ¹⁶⁰ In today's environment, where a complex may choose between organizing a single series company with multiple portfolios or multiple investment companies each with a single portfolio, we believe that requiring disclosure of the number of portfolios that a director oversees would provide a more accurate picture of the director's responsibilities.

The Commission seeks comment on whether the proposed basic information would provide shareholders with sufficient information about the directors who are charged with protecting shareholder interests. If the disclosure would not achieve this purpose, is there other basic information about directors that should be required? If proposed disclosure of any item is not necessary or useful to investors, please explain the reason why. Should the same basic information be included in the SAI, annual report, and proxy statement?

2. Ownership of Equity Securities in Fund Complex

As discussed above, some have complained that shareholders do not know whether directors' interests are aligned with those of shareholders. ¹⁶¹ Although a director need not necessarily hold securities of funds in a fund complex to be an effective advocate for shareholders, the interests of a director who holds shares in the complex will tend to be aligned with the interests of other shareholders. ¹⁶² We are therefore proposing to require disclosure of the aggregate dollar amount of equity securities of funds in the fund complex owned beneficially and of record by each director. ¹⁶³

We are not proposing to require separate disclosure of a director's holdings of equity securities in the fund itself. We are concerned that this information might have limited meaning because of the many reasons that a director could have for not holding shares of any specific fund, e.g., that its investment objective did not fill a need in the director's portfolio.

Funds would provide information on director holdings in an easy-to-read tabular format including: (1) name of director; (2) identity of fund complex; and (3) aggregate dollar amount of equity securities owned of funds in the complex. The information, as of the most recent practicable date, would be provided in the fund's SAI and in any proxy statement relating to the election of directors. This would ensure that the information is available to prospective investors upon request and is provided to shareholders whenever they are asked to vote to elect directors. ¹⁶⁴

"Fund complex" is currently defined in the proxy rules as two or more funds that (1) hold themselves out to investors as related companies for purposes of investment and investor services; or (2) have a common investment adviser or an investment adviser that is an affiliated person of the investment adviser of any of the other funds. ¹⁶⁵ The Commission is proposing to use this definition to determine a director's holdings in a fund complex. ¹⁶⁶

We request comment on whether information on director holdings of shares in a fund complex would be useful to shareholders. If so, should the Commission use the definition of "fund complex" that is currently contained in the proxy rules? Or should the Commission use another definition, such as "family of investment companies" used in Form N-SAR? ¹⁶⁷ Should disclosure of director holdings be limited to holdings in the fund itself, the group of funds overseen by a director, or some other group of funds? The Commission also requests comment on whether there is other information that bears on the alignment of interests of shareholders and directors and should be disclosed.

3. Conflicts of Interest

a) Statutory Scheme Governing Conflicts of Interest

As described above, Congress provided that at least 40 percent of the board of directors of an investment company must be independent and assigned a special role to the independent directors -- to supply a check on management and act as independent watchdogs for investors. ¹⁶⁸ Under the Investment Company Act, an independent director is an individual who is not an "interested person" of the fund. ¹⁶⁹

In section 2(a)(19) of the Act, Congress enumerated individuals who are "interested persons" of a fund and who, therefore, are not considered independent directors. These individuals include (1) any affiliated person of the fund, (2) any member of the immediate family of any natural person who is an affiliated person of the fund, (3) any interested person of any investment adviser of or principal underwriter for the fund, (4) any person or partner or employee of any person who at any time since the beginning of the last two completed fiscal years of the fund has acted as legal counsel for the fund, and (5) any broker or dealer registered under the Exchange Act or any affiliated person of a broker or dealer. ¹⁷⁰

Congress also gave the Commission authority to determine by order that a director is an interested person even though he is not covered by the categories enumerated in the statute. ¹⁷¹ The Commission may determine that a natural person is an interested person of a fund by reason of having had, at any time since the beginning of the last two completed fiscal years of the fund, a material business or professional relationship with the fund, the principal executive officer of the fund, any other investment company having the same investment adviser or principal underwriter, or the principal executive officer of the other investment company. ¹⁷² We also may determine that a natural person is an interested person of an investment adviser or principal underwriter of a fund (and therefore of the fund itself) by reason of having had, at any time since the beginning of the last two completed fiscal years of the fund, a material business or professional relationship with the investment adviser or principal underwriter or with the principal executive officer or any controlling person of the investment adviser or principal underwriter. ¹⁷³ For example, in appropriate circumstances, the Commission may find that a director who was an employee of a fund's investment adviser within the past two years is an "interested person" under section 2(a)(19)(B)(vi) of the Act by reason of having a material business or professional relationship with the investment adviser. ¹⁷⁴

b) Need for Disclosure Changes

The proxy rules currently require significant information about conflicts of interest of directors. ¹⁷⁵ The proxy rules require disclosure of positions held with the investment adviser and any securities holdings or material interests in the investment adviser and any person controlling, controlled by, or under common control with the investment adviser. ¹⁷⁶ A mutual fund also must disclose any material interests of a director in the fund's principal underwriter or administrator. ¹⁷⁷ In addition, a fund must disclose any material interests of a director in any material transactions with the fund, the investment adviser, the principal underwriter, the administrator, or any person controlling, controlled by, or under common control with the investment adviser, principal underwriter, or administrator. ¹⁷⁸

We are proposing to enhance the disclosure required in the proxy rules because we believe that there are other situations that could involve conflicts of interest. We also are proposing to include the proposed conflicts disclosure about directors in the SAI because mutual funds no longer prepare proxy statements on a regular basis. ¹⁷⁹

We believe disclosure of directors' potential conflicts of interest would serve three purposes. First, this disclosure would bring to the attention of shareholders circumstances that may affect the directors' allegiance to shareholders. With this information, shareholders may decide for themselves whether an independent director has any potential conflicts of interest that could affect the director's ability to protect the interests of shareholders.

Second, disclosure would provide the public, including the press and other third-party information providers, access to information about directors' potential conflicts of interest. The resulting public dissemination may discourage the selection of independent directors who have relationships or engage in activities that raise questions about their independence.

Third, the information would assist the Commission in evaluating whether it should exercise its authority to determine that a director is "interested" under section 2(a)(19)(A)(vi) or (B)(vi) of the Act even though he is not within one of the categories of "interested persons" specifically enumerated by Congress in other provisions of section 2(a)(19). ¹⁸⁰ The legislative history of section 2(a)(19) states that the Commission could issue an order determining that a director is an interested person if the Commission found that a director's "business or professional relationship [with certain related persons] was material in the sense that it might tend to impair the independence of such director." ¹⁸¹ In providing the Commission with this authority, Congress contemplated that the Commission would look at each situation on a case-by-case basis. ¹⁸² The proposed disclosure would assist the Commission in determining whether it would be appropriate to make a further inquiry into a director's independence.

We believe that the proposed disclosure would give shareholders the tools to help determine how effectively the directors serve their interests and encourage the selection of directors that are independent in the spirit intended by Congress. We first discuss our general approach to the disclosure requirements and then discuss the specific requirements.

c) General Approach to Disclosure

(1) Circumstances Raising Potential Conflicts of Interest

The Commission is proposing to require disclosure of three types of circumstances that could affect the allegiance of mutual fund directors to their shareholders: positions, interests, and transactions and relationships of directors. In specifying the circumstances where disclosure is required, we have drawn on the current proxy rules, which require disclosure of positions, interests, and transactions of directors. ¹⁸³

The Commission is proposing to require disclosure of positions held by a director with the fund and persons related to the fund. ¹⁸⁴ A director who holds such a position may be influenced to act in the interest of persons related to the fund rather than the interest of fund shareholders. We also are proposing to require disclosure of directors' interests, including securities holdings, in entities related to the fund. ¹⁸⁵ A director who holds an interest in an entity related to the fund may be tempted to place his financial interest in the entity ahead of shareholders' interests in the fund. Finally, we are proposing to require disclosure of directors' transactions and relationships with the fund and persons related to the fund. ¹⁸⁶ A director who is involved in a transaction or relationship with the fund or related persons may have financial or other interests that compete with those of fund shareholders.

The Commission requests comment on whether disclosure of directors' positions, interests, and transactions and relationships is appropriate. Are there other types of circumstances that also raise conflict of interest concerns and should be disclosed?

(2) Persons Covered by Disclosure Requirements

Directors and Immediate Family Members

The Commission is proposing to follow the approach taken in the current proxy rules and require conflicts of interest disclosure about all directors, both interested and independent. ¹⁸⁷ The Commission requests comment on whether this approach is appropriate, or whether there are any proposed requirements that should apply only to independent directors. If so, which requirements should apply only to independent directors?

The Commission also proposes to extend the disclosure requirements to the immediate family members of directors because the involvement of family members with the fund or persons related to the fund could raise the same conflicts of interest for a director as if the director was involved directly in the situation. The Commission proposes to define "immediate family member" to mean any spouse, parent, child, sibling, mother- or father-in-law, son- or daughter-in-law, or sister- or brother-in-law, including step and adoptive relationships. ¹⁸⁸ This definition is similar to the definition of immediate family member in the current proxy rules. ¹⁸⁹ We are proposing to add step and adoptive relationships, based on the definition of "immediate family member" in section 2(a)(19) of the Act. Our proposed definition would be slightly broader than the definition in section 2(a)(19) of the Act, which does not include mother- or father-in-law or sister- or brother-in-law relationships. We request comment on whether the proposed definition is appropriate, or whether it should be expanded or narrowed.

Related Persons

The Commission is proposing to require disclosure about circumstances involving directors, on the one hand, and the fund and persons related to the fund, on the other. We looked to the Act for guidance in determining which related persons should be covered by our disclosure requirements. The Commission's statutory authority to determine that a director is an "interested person" is based on finding a relationship with the fund; its investment adviser, principal underwriter, or a person controlling the investment adviser or principal underwriter; another investment company with the same investment adviser or principal underwriter; or the principal executive officer of the fund, its investment adviser or principal underwriter, or another investment company with the same investment adviser or principal underwriter. ¹⁹⁰

We are proposing to require disclosure with respect to circumstances involving these persons and other persons that we have concluded may pose similar conflicts of interest. The additional persons include: (1) a fund's administrator or a person directly or indirectly controlling the administrator; (2) a person directly or indirectly controlled by or under common control with the fund's investment adviser, principal underwriter, or administrator; (3) any other investment company with the same administrator as the fund; (4) any other investment company with an investment adviser, principal underwriter, or administrator that directly or indirectly controls, is controlled by, or is under common control with an investment adviser, principal underwriter, or administrator of the fund; and (5) any officer of (i) the fund; (ii) the investment adviser, principal underwriter, or administrator of the fund; (iii) a person directly or indirectly controlling, controlled by, or under common control with the fund's investment adviser, principal underwriter, or administrator; (iv) an investment company with the same investment adviser, principal underwriter, or administrator as the fund; or (v) an investment company with an investment adviser, principal underwriter, or administrator that directly or indirectly controls, is controlled by, or is under common control with an investment adviser, principal underwriter, or administrator of the fund. ¹⁹¹

We are following the approach of the current proxy rules in proposing to require disclosure regarding directors' relationships with mutual fund administrators. As administrators take on an increasing role in the operations of funds, the relationships of independent directors with these entities may affect the directors' ability to safeguard the interests of fund shareholders. ¹⁹²

As in the current proxy rules, we are proposing to require mutual funds to disclose circumstances involving the director and persons controlling, controlled by, or under common control with some parties related to the fund. ¹⁹³ We believe that situations involving a director and persons controlled by or under common control with persons related to the fund could pose conflicts of interest that are similar to situations involving controlling persons, which are referenced in section 2(a)(19) of the Act. We are concerned that the burden on mutual funds of expanding disclosure beyond these persons, however, may outweigh the value of the information to investors. The Commission requests comment on whether it should extend the proposed disclosure requirements beyond persons controlling, controlled by, or under common control with parties related to the fund, or limit the proposed disclosure requirements to controlling persons as specified in section 2(a)(19) of the Act.

As noted above, we also are proposing to require disclosure of circumstances involving any officer of (1) the fund; (2) the investment adviser, principal underwriter, or administrator of the fund; (3) a person directly or indirectly controlling, controlled by, or under common control with the fund's investment adviser, principal underwriter, or administrator; (4) an investment company with the same investment adviser, principal underwriter, or administrator as the fund; or (5) an investment company with an investment adviser, principal underwriter, or administrator that directly or indirectly controls, is controlled by, or is under common control with an investment adviser, principal underwriter, or administrator of the fund. We are proposing to require disclosure for all officers who perform policy-making functions, not only the principal executive officer as referred to in sections 2(a)(19)(A)(vi) and (B)(vi) of the Act, because we believe that situations involving a director and other officers may raise conflict of interest concerns that are similar to those involving a director and the principal executive officer. Form N-1A defines "officer" to mean president, vice-president, secretary, treasurer, controller, or any other officer who performs policy-making functions. ¹⁹⁴ We are proposing to add this definition to the proxy rules. ¹⁹⁵

The Commission requests comment on the scope of its general approach to disclosure outlined above, including whether there are any other circumstances that could raise potential conflicts of interest that should be disclosed, and whether the scope of persons covered by the disclosure requirements is appropriate. Having discussed the general concepts of our proposal, we now turn to the specific proposed requirements for disclosure in the SAI and proxy statements for the election of directors.

d) Specific Disclosure in the Proxy Rules and SAI

(1) Positions

The Commission is proposing to require disclosure of any positions, including as an officer, employee, director, or general partner, held during the past five years by directors and their immediate family members with: (1) the fund; (2) an investment company having the same investment adviser, principal underwriter, or administrator as the fund or an investment adviser, principal underwriter, or administrator that controls, is controlled by, or is under common control with the fund's investment adviser, principal underwriter, or administrator; ¹⁹⁶ (3) an investment adviser, principal underwriter, administrator, or affiliated person of the fund; or (4) any person controlling, controlled by, or under common control with the fund's investment adviser, principal underwriter, or administrator. ¹⁹⁷

We request comment on the proposed disclosure of director positions. Should we limit the disclosure required to certain positions, such as managerial or policy-making positions? Have we appropriately specified the entities with respect to which positions should be disclosed? Should any entities be added to or eliminated from the required disclosure? Should disclosure be required for five years as proposed consistent with the current proxy rules, or for a longer or shorter period? ¹⁹⁸

(2) Interests

The Commission is proposing to require disclosure of securities currently owned, and material direct or indirect interests held during the past five years, by each director and his immediate family members in (i) an investment adviser, principal underwriter, or administrator of the fund; or (ii) a person (other than a registered investment company) directly or indirectly controlling, controlled by, or under common control with an investment adviser, principal underwriter, or administrator. ¹⁹⁹ Information about securities owned would be provided in a table, including the value of the securities and percent of each class owned. ²⁰⁰ The value of the securities and percent of each class owned would be provided in the aggregate for each director and his immediate family members. ²⁰¹ This information would be provided as of the most recent practicable date. ²⁰²

We request comment on the proposed disclosure of director interests. Have we appropriately defined the scope of the interests required to be disclosed? Should disclosure be required of current securities ownership, and of material interests for the past five years, as in the current proxy rules, or should longer or shorter periods be used? Should securities ownership be aggregated or presented separately for a director and his immediate family members? Should the Commission establish any de minimis threshold for the disclosure of material interests? If so, what should it be, e.g., interests exceeding $5,000, $10,000, $50,000, or some other amount?

(3) Transactions and Relationships

Transactions and Relationships Generally

The Commission is proposing to require disclosure of transactions and relationships of directors with the fund and parties related to the fund. The parties related to the fund that would be covered by this requirement are: (i) an officer of the fund; (ii) an investment company having the same investment adviser, principal underwriter, or administrator as the fund or having an investment adviser, principal underwriter, or administrator that directly or indirectly controls, is controlled by, or is under common control with an investment adviser, principal underwriter, or administrator of the fund; ²⁰³ (iii) an officer of an investment company described in (ii); (iv) an investment adviser, principal underwriter, or administrator of the fund; (v) an officer of an investment adviser, principal underwriter, or administrator of the fund; (vi) a person directly or indirectly controlling, controlled by, or under common control with an investment adviser, principal underwriter, or administrator of the fund; or (vii) an officer of a person directly or indirectly controlling, controlled by, or under common control with an investment adviser, principal underwriter, or administrator of the fund (together "Related Parties"). ²⁰⁴

We are proposing to require disclosure of any material interest, direct or indirect, of any director or his immediate family member in any material transaction, or material series of similar transactions, since the beginning of the last two completed fiscal years (or currently proposed), to which the fund or a Related Party was or is to be a party. ²⁰⁵ Transactions would include loans, lines of credit, and other indebtedness.

For material interests in material transactions, a mutual fund would be required to state the name of the director or family member whose interest is described, the nature of the circumstances by reason of which the interest is required to be described, the nature of the interest, the approximate dollar amount involved in the transaction, and, where practicable, the approximate dollar amount of the interest. ²⁰⁶ For indebtedness, a mutual fund would be required to indicate the largest aggregate amount of indebtedness outstanding at any time during the period, the nature of the indebtedness and the transaction in which it was incurred, the amount outstanding as of the latest practicable date, and the rate of interest paid or charged. ²⁰⁷

We also are proposing to require disclosure of any material relationship, direct or indirect, of any director or his immediate family member that exists, or has existed at any time since the beginning of the last two completed fiscal years, or is currently proposed, with the fund or a Related Party. Relationships would include payments for property or services, provision of legal or investment banking services, and any consulting or other relationship that is substantially similar in nature and scope to any of the foregoing relationships. ²⁰⁸

For material relationships, a fund would be required to state the name of the director or family member whose relationship is described, the nature of the circumstances by reason of which the relationship is required to be described, the nature of the relationship, and the amount of business done between the director or family member and the fund or Related Party since the beginning of the last two completed fiscal years or proposed to be done during the current fiscal year. ²⁰⁹

A fund would not be required to disclose routine, retail transactions and relationships between directors or immediate family members and the fund or Related Parties. For example, a mutual fund need not disclose that a director holds a credit card or bank or brokerage account with a fund or Related Party, unless the director is accorded special treatment, such as preferred access to initial public offerings. ²¹⁰

Indirect, as well as direct, material interests in material transactions and material relationships would be required to be disclosed. A director or family member who has a position or a relationship with, or interest in, a company that engages in a transaction or has a relationship with a fund or Related Party may have an indirect interest in the transaction or an indirect relationship by reason of the position, relationship, or interest. ²¹¹ The interest in the transaction or the relationship of the director or family member, however, would not be deemed material if the interest or the relationship arises solely from the holding of an equity interest (excluding a general partnership interest) or a creditor interest in a company that engages in a transaction or has a relationship with the fund or Related Party if the transaction or the relationship is not material to the company.

We request comment on the proposed disclosure of director transactions and relationships. Have we appropriately defined the scope of transactions and relationships to be disclosed? Should disclosure be required for the period since the beginning of the last two completed fiscal years, as proposed based on the time period specified in section 2(a)(19) of the Act, ²¹² or only since the beginning of the most recently completed fiscal year as required in the current proxy rules, or for some other time period?

We also request comment on whether we should specify a minimum dollar amount involved in a transaction or relationship that would trigger the disclosure requirements rather than simply requiring disclosure of "material" transactions or relationships. If so, what should the threshold be, e.g., transactions exceeding $60,000, or some other amount? ²¹³ Similarly, should we require disclosure of transactions or relationships only when the interest of a director or his immediate family member is greater than a specified dollar amount? If so, what should the dollar amount be, e.g., interests exceeding $5,000, $10,000, $50,000, or some other amount?

We also request comment on whether we should limit disclosure of transactions or relationships where the interest of a director or his immediate family member arises indirectly through ownership of an interest in a company that is involved in a transaction or relationship with a fund or Related Party. For example, should disclosure of a transaction or relationship not be required when a director and his immediate family members, in the aggregate, have less than a specified threshold interest in a company that is a party to the transaction or relationship with the fund or Related Party? ²¹⁴ If so, what should the threshold percentage be, e.g. 5%, 10%, or some other amount? Or should the Commission set a threshold dollar amount ownership interest in the company? If so, what should the dollar amount be, e.g., $5,000, $10,000, $50,000, or some other amount? In determining whether the threshold is exceeded, should a director's interests be aggregated with those of his immediate family members, other directors or nominees, executive officers, security holders who own more than 5% of any class of the registrant's voting securities, or any other persons? ²¹⁵

Cross-Directorships

Finally, the Commission is proposing to require a mutual fund to disclose situations where an officer of an investment adviser, principal underwriter, or administrator of a fund, or an officer of a person directly or indirectly controlling, controlled by, or under common control with an investment adviser, principal underwriter, or administrator of the fund serves, or has served since the beginning of the last two completed fiscal years of the fund, as a director of a company of which a fund director or his immediate family member is, or was, an officer. ²¹⁶ The fund would be required to identify (i) the company involved; (ii) the individual who serves or has served as a director of the company and the period of service as director; (iii) the investment adviser, principal underwriter, or administrator, or person controlling, controlled by, or under common control with the investment adviser, principal underwriter, or administrator where the individual named in (ii) holds or held office and the office held; and (iv) the director of the fund or immediate family member who is or was an officer of the company, the office held, and the period of holding office.

We believe that cross-directorships could potentially create a conflict of interest for a director because the position that he or his immediate family member holds in another company could be affected by an officer of the investment adviser, principal underwriter, or administrator, or an officer of a party controlling, controlled by, or under common control with the investment adviser, principal underwriter, or administrator. ²¹⁷ We request comment on the proposed disclosure of cross-directorships. Have we appropriately defined the scope of the circumstances to be disclosed? Should disclosure be required for a shorter or longer period than since the beginning of the last two completed fiscal years of the fund?

4. Board's Role in Fund Governance

The Commission is proposing to modify disclosure of matters related to the board's role in governing a fund currently required in the proxy rules and the SAI. We believe that this information would help shareholders more readily determine whether the directors are effectively representing shareholders' interests, independent of fund management.

The proxy rules require a mutual fund to discuss in reasonable detail the material factors and conclusions that formed the basis for the board of directors' recommendation that the shareholders approve an investment advisory contract, including a discussion of any benefits derived or to be derived by the investment adviser from the relationship with the fund such as soft dollar arrangements by which brokers provide research to the fund or its investment adviser in return for allocating fund brokerage. ²¹⁸ We are proposing to require similar disclosure in the SAI so that investors will be able to evaluate the board's basis for approving the renewal of an existing investment advisory contract. ²¹⁹

Director responsibility for evaluating and approving a mutual fund's advisory contract is one of the most important fund governance obligations assigned to directors under the Investment Company Act. ²²⁰ In approving an investment advisory contract, independent directors must review the level of fees charged to a fund by an investment adviser. Participants at the Roundtable discussed the important role of independent directors in negotiating these fees and expenses. ²²¹ We believe that a discussion of the factors considered by the board in retaining an investment adviser will help investors understand and evaluate the board's basis for that action.

We also are proposing to modify disclosure in the proxy rules and the SAI relating to a fund's committees of the board of directors. The proxy rules currently require mutual funds to disclose information about standing audit, nominating, and compensation committees. ²²² In the SAI, mutual funds are required to identify members of any executive or investment committee, and provide a concise statement of the duties and functions of each committee. ²²³

We are proposing to modify this disclosure to require mutual funds to identify each standing committee of the board in the SAI and proxy statements for the election of directors. As in the current proxy rules, funds would be required to provide a concise statement of the functions of each committee; identify the members of the committee; indicate the number of committee meetings held during the last fiscal year; and state whether its nominating committee will consider nominees recommended by fund shareholders and, if so, describe the procedures for submitting recommendations. ²²⁴

5. Separate Disclosure

Currently, mutual funds must indicate with an asterisk the directors who are interested persons of the fund within the meaning of section 2(a)(19) of the Act for certain disclosure items in the proxy statements and the SAI. ²²⁵ To provide more prominent disclosure about independent directors, we are proposing to require funds to present all disclosure for independent directors separately from disclosure for interested directors in the SAI, proxy statements for the election of directors, and annual reports to shareholders. ²²⁶ For example, when information is furnished in a table, funds should provide separate tables (or separate sections of a single table) for independent directors and for interested directors. When presenting information in narrative form, funds should clearly indicate, by heading or other means, which directors are interested and which are independent.

6. Technical and Conforming Amendments

The Commission is proposing to clarify that Item 22 of Schedule 14A applies to business development companies. ²²⁷ This proposed change reflects current requirements.

The Commission is proposing changes to cross-references in Items 8 and 10 of Schedule 14A to reflect the proposed amendments to Item 22 of Schedule 14A. We also are proposing to amend current Item 22(b)(4) of Schedule 14A. This item requires funds to provide the information required by Items 401, 404(a) and (c), and 405 of Regulation S-K. Because proposed Item 22(b)(7) of Schedule 14A requires much of the information now required by Item 401 of Regulation S-K, we are proposing to modify Item 22(b)(4) of Schedule 14A to require funds to provide the information required by Items 401(f) and (g), 404(a) and (c), and 405 of Regulation S-K. ²²⁸

Because we have defined the term "officer" to mean the president, vice-president, secretary, treasurer, controller, or any other officer who performs policy-making functions, we are proposing to change the reference in the compensation table from "executive officer" to "officer." ²²⁹ In addition, we are proposing to amend the definition of "administrator" in the proxy rules to conform to the proposed definition of "administrator" in rule 0-1(a)(5). ²³⁰

We also are proposing conforming changes to the SAI. Because we are proposing enhanced disclosure about directors' positions, we are proposing to require disclosure of officers' positions, which remains unchanged, as a separate item. ²³¹ We are proposing amendments to the SAI to conform to the proxy rules by requiring a brief description of any arrangement or understanding between a director or officer and any other person pursuant to which he was selected as a director or officer. ²³²

We also are proposing changes to rule 30d-1 under the Investment Company Act. ²³³ Rule 30d-1(d) allows a fund to send to shareholders a copy of its currently effective prospectus or SAI, or both, instead of a shareholder report required by the rule, provided that the prospectus or SAI, or both, include certain financial information and information about directors' compensation. We are proposing to amend the rule to require a prospectus or SAI, or both, serving as a shareholder report to include all the information that would otherwise be required in the shareholder report. ²³⁴

7. Compliance Date

If we adopt the proposed disclosure requirements, we expect to require all new registration statements and post-effective amendments that are annual updates to effective registration statements, proxy statements for the election of directors, and reports to shareholders filed on or after the effective date of the amendments to comply with the proposed amendments. The Commission requests comment on this proposed compliance date.

F. Recordkeeping Regarding Director Independence

To assure that independent directors are able to fully carry out the important duties assigned to them, the Act and our rules establish standards concerning their financial and other interests. ²³⁵ A fund must determine whether the individuals who serve as independent directors in fact satisfy these standards when it prepares certain disclosure documents for investors. ²³⁶ The process that a fund uses to make these determinations should reflect diligent efforts to evaluate each director's relevant business and personal relationships that might affect his independent judgment.

We are proposing to amend our rule requiring funds to preserve certain records to enable the Commission to monitor funds' assessments of the independence of their directors. The proposed amendment would require funds to preserve any record of the initial determination that a director qualifies as an independent director, and each subsequent determination of whether the director continues to qualify as an independent director. ²³⁷ We propose that funds preserve these documents for a period of six years, the first two years in an easily accessible place. ²³⁸

Because funds already should be collecting relevant information when they make and review their determinations of director independence, ²³⁹ we believe that our proposed recordkeeping requirement would not impose substantial costs or other burdens on funds. Comment is requested on the necessity of this information, and on the costs of maintaining these records. We also request comment on the effects that this proposed recordkeeping requirement would have on funds' internal compliance policies and procedures. Are there feasible alternatives to the proposal that would enable the Commission to monitor funds' assessments of the independence of their directors, while minimizing the burdens imposed on funds? ²⁴⁰

G. General Request for Comments

The Commission requests comment on the new rules, rule amendments, and form amendments proposed in this Release, suggestions for additional provisions or changes to existing rules or forms, and comments on other matters that might have an effect on the proposals contained in this Release. We also request comment whether the proposals, if adopted, would promote efficiency, competition, and capital formation. We will consider those comments in satisfying our responsibilities under section 2(c) of the Investment Company Act, section 2(b) of the Securities Act, and section 3(f) of the Exchange Act. ²⁴¹ For purposes of the Small Business Regulatory Enforcement Fairness Act of 1996, ²⁴² we also request information regarding the potential effect of the proposals on the U.S. economy on an annual basis. Commenters are requested to provide empirical data to support their views.

As discussed above, the ICI Advisory Group Report recommended several measures that are similar to our proposed amendments as well as several additional practices and policies. We request comment whether we should adopt any of these "best practices" recommendations as further measures to enhance the effectiveness of independent directors. ²⁴³

III. COST-BENEFIT ANALYSIS

The Commission is sensitive to the costs and benefits imposed by its rules.

A. Proposed Amendments to the Exemptive Rules

The Commission is proposing to amend the Exemptive Rules ²⁴⁴ to require that, for funds relying on those rules: (i) independent directors constitute either a majority or a super-majority (two-thirds) of their boards; (ii) independent directors select and nominate other independent directors; and (iii) any legal counsel for the fund's independent directors be an independent legal counsel. These proposals are designed to enhance the independence and effectiveness of fund directors who are charged with overseeing the fund's activities and transactions that are covered by the Exemptive Rules. Boards that meet these conditions should be more effective at exerting an independent influence over fund management. Their independent directors should be more likely to have their primary loyalty to the fund's shareholders rather than the adviser, and should be better able to evaluate the complex legal issues that are often faced by fund boards with an independent and critical eye. These proposed amendments, therefore, would provide substantial benefits to shareholders by helping to ensure that independent directors are better able to fulfill their role of representing shareholder interests and supplying an independent check on management.

The proposed amendments to the Exemptive Rules may impose some costs on funds that choose to rely on those rules. Funds that do not rely on an Exemptive Rule, however, will not be subject to the proposed conditions, or any costs associated with those conditions. These costs are discussed below.

Independent directors as a majority of the board. First, the Commission is making two alternative proposals regarding the representation of independent directors on fund boards. Under one proposal, funds relying on the Exemptive Rules would be required to have independent directors constitute a simple majority of their boards. Because, as noted above, most mutual funds today have boards with independent majorities, ²⁴⁵ it appears that this proposal would not impose substantial costs on funds as a group. Under the alternative proposal, funds relying on the Exemptive Rules would be required to have independent directors constitute two-thirds of their boards. Because fewer funds currently have boards of which two-thirds of the directors are independent, this alternative proposal could have higher costs for funds as a group. ²⁴⁶

Under either of these alternative proposals, funds that currently do not have the required percentage of independent directors on their boards (whether a simple majority or two-thirds) and that would like to rely on the Exemptive Rules may incur some costs. The Commission, however, has no reasonable basis for estimating those costs. Those funds could come into compliance with either alternative proposal in a number of ways. For example, funds could: (i) decrease the size of their boards and allow some inside directors to resign; (ii) maintain the current size of their boards and replace some inside directors with independent directors; or (iii) increase the size of their boards and elect new independent directors.

Where new independent directors are elected, whether to replace inside directors or to fill new positions that expand the size of the board, the fund would incur the costs of preparing a proxy statement and holding a shareholder meeting to elect those independent directors, as well as the costs of compensating those directors. ²⁴⁷ The Commission, however, has no reasonable basis for determining how many funds that currently do not have independent directors as a simple majority of their boards would choose to comply with either proposal through electing new independent directors. Similarly, we have no reasonable basis for determining how many funds that currently have independent directors as a simple majority, but not as a two-thirds majority, would choose to comply with the alternative proposal through electing new independent directors. We also have no reasonable basis for estimating the average compensation that would be paid to those newly elected independent directors, or the costs to those funds of preparing proxy statements and holding shareholder meetings to elect those directors.

We request comment on the potential costs of each of these alternative proposals. Comment is specifically requested on the differences in costs to funds of the two alternatives.

Independent director self-selection and self-nomination. Second, the proposed amendments to the Exemptive Rules would require that independent directors select and nominate any other independent directors. It appears that this proposal would not impose significant new costs on funds, because many funds already have adopted this practice. ²⁴⁸ Although some funds do not currently follow this practice and would need to adopt it in order to rely on the Exemptive Rules, we are not aware of any costs that would result from requiring a fund's incumbent independent directors to select and nominate other independent directors. Comment is requested on the costs associated with independent director self-selection and self-nomination. Are those costs greater than the costs that would otherwise be incurred by a fund in selecting qualified independent directors?

Independent legal counsel. Finally, the proposed amendments to the Exemptive Rules would require that any legal counsel to a fund's independent directors be an