BOARD SERVICES CORPORATION
Leslie L. Ogg, President
February 26, 2004
Jonathan G. Katz, Secretary
Securities and Exchange Commission
450 Fifth Street, NW
Washington, DC 20549-0609
RE: File No. S7-03-04
Investment Company Governance
Dear Mr. Katz:
I am pleased to have an opportunity to comment on the proposed rule regarding investment company governance. Board Services Corporation supports the work of independent directors and is retained as an administrator by the AXP funds which are managed by American Express Financial Corporation.
The proposed rule requires that 75% of the board of a fund be composed of independent directors and that these directors select the new independent directors. The AXP funds Boards meet these two requirements and have done so for 40 years. The proposed rule also requires an independent director serve as chair, a requirement which the AXP funds' Boards imposed when they determined to have a super majority of their directors independent of the investment manager.
In addition, the proposed rule requires that independent directors meet without interested directors and have the right to retain help in fulfilling their oversight responsibility. The AXP funds' independent directors meet without interested directors being present before meetings of the Boards and occasionally at other times. The independent directors also have retained persons including legal counsel who do not represent investment managers to assist them in meeting their fiduciary responsibility.
Based on their experience, the AXP funds' independent directors continue to employ the same board structure that is set forth in the proposed rule which requires:
- a super majority of truly independent directors,
- an independent director serve as Chair,
- separate meetings of independent directors, and
affords the option to hire staff and consultants as needed to assure independence and control of the agenda.
The AXP funds' Boards do not have a formal process for self-assessment. At the Independent Directors' Meeting, independent directors have freely expressed their views on ways to improve the committee structure, the content of the meeting material contained in their board books, the conduct of a meeting, and the quality of presentations. There is a committee of each Board that has been given the assignment to assess various aspects of board and committee structure and the effectiveness of the processes used by the Boards to cover the agenda. For the most part, the comments made by individual directors about how to make meetings more effective have not been recorded. It is my view that the AXP funds' independent directors have no objection to holding a formal meeting annually to review the effectiveness of their committee structures and to make a finding regarding their ability to oversee the funds in the complex.
As for the proposal to amend the rule covering retention of records, the AXP funds' Boards meet the proposed requirement. On a number of occasions the Securities and Exchange Commission (SEC) inspections teams have reviewed the series of four annual reports and other material used by the Contracts Committees and the Boards to review contracts, including the distribution agreements, the transfer agency agreements, the agreements with affiliated custodian, and the 12b-1 and service fees. The proposed amendment to the recordkeeping rule is a change to an administrative function and does not require more than a perfunctory statement. However, the release proceeds with a discussion that raises a serious question. It states:
Section 15 (of the Investment Company Act of 1940, as amended) requires that fund directors, including a majority of independent directors, approve the fund's advisory contract each year. It also requires that the directors first obtain from the adviser the information reasonably necessary to evaluate the contracts.
The last sentence is supported by footnote 52 which cites the Congressional record in 1969 noting that "this provision was intended to 'facilitate well-informed directorial consideration of the matters related to advisory fees' and ensure that 'the attention of the directors will be fixed on their responsibilities."
The next two paragraphs of the release highlight the problem. They state:
The information request requirement in section 15 provides fund directors, including independent directors, a tool for obtaining the information they need to represent shareholder interests. Careful consideration of the information enables them to better negotiate the amount of the advisory fee. Conversely, the failure of a board to acquire information sufficient to scrutinize the advisory fee and other fund expenses can suggest an inability or lack of interest on the part of the board in negotiating on behalf of the fund. In this regard, the Mutual Fund Directors Forum, an independent organization that advises fund directors, is preparing best practices recommendations for directors on the type of information that they should request and consider when reviewing advisory contracts.
As part of our examinations of funds, our staff has reviewed the materials that directors considered in approving the advisory contract, if the materials were available. Our examiners have found that the nature and quality of these materials vary widely among funds. Some funds boards have failed to request the materials they need to make an informed assessment of the advisory contract. In one case, we brought an enforcement action against directors who neglected to request and evaluate sufficient information under section 15(c).
Why the SEC used this release to discuss enforcement action against independent directors based on the determination of its examiners that the independent directors fail to obtain and evaluate "sufficient information" is unclear. However, since it did I will:
- restate the position that the AXP funds' independent directors have expressed with regard to Section 15(c),
- describe my expectation about the role of the Mutual Fund Directors Forum, and
- make observations regarding the effort of the SEC staff to support the work of independent directors.
The independent directors and I believe and the SEC found that compliance failures have occurred when a fund service provider has denied information to the fund's board, or has been less than forthright, because the service provider viewed full disclosure as detrimental to its own interests. This point generally has not been made by presenters at Congressional hearings and has been largely ignored by the media. As a result the impression has been left that independent directors were not doing their job because they failed to ask the right questions.
Set forth in their January 8, 2004, comment letter on compliance programs to the SEC, the AXP funds' independent directors expressed their believe that Section 15(c) needs to be revised in order to make it the obligation of service providers to provide independent directors relevant information. The independent directors have asked members of Congress and their staffs to consider making such a revision.
Boards must be assured of a timely flow of accurate information in order to do their job. Investment adviser representatives recently took the position that Section 15(c) should not be revised because it places a fund's board in ultimate control of what information is important. Boards cannot control the flow of information about business practices unless they know the investment adviser or principal underwriting is engaging in these practices. If Section 15(c) is amended and the flow of information is assured, most of the provisions in the many bills that have been introduced in Congress are not needed. The rules being proposed by the Commission to address the same subjects that are covered by the proposed legislation will then have the foundation they need to be effective and minimize the likelihood of future misadventures.
It is my view that if the SEC intends to use its examiners to determine whether a board has failed to request and evaluate the material they need, additional directives must be given to independent directors. This is particularly true if the determination
- is made in light of some future misadventure of the types we are witnessing today or
- is based on each examiner's concept of what information is needed to review the level and quality of services provided
One such directive is given in the release. It states that the Mutual Fund Directors Forum is preparing best practices recommendations for directors on the types of information that they should request and consider. What is missing in this directive is some guidance as to what weight will be given by the SEC to these best practices?
The release also implies that the SEC has its own vision of what information should be requested and considered. It is important that that vision be made known to the independent directors. For example, one facet of that vision is included in the release adopting Rule 38a-1. Can it be concluded that if the independent directors receive an annual report that covers material violations of federal securities laws, policies and procedures, and weakness in design of policies and procedures, they have done enough to address the conflicts within a service provider that often gives rise to misadventures?
Further, the topics about which independent directors need to have information are constantly changing. The SEC, itself, must be one source of that information.
There are two parts to the SEC' observations regarding why compliance failures occurred in its release adopting investment company compliance programs. The first observation is that compliance failures occur when a fund service provider denies information to a fund's board. SEC inspection teams are a critical component for discovering this conduct. Everything they learn during an inspection must be shared with the independent directors and the SEC must implement processes that communicate directly with the independent directors.
The second observation is that compliance failures occur when a service provider has been less than forthright because the service provider viewed full disclosure as detrimental to its own interest. Often the business practices about which service providers are less than forthright are wide-spread throughout the industry. Unless the reasons why the full disclosures about these practices will be detrimental to the service providers are explained, the independent directors cannot properly evaluate the situation and make an informed assessment of the practice. It is incumbent on the SEC as well as those who provide education opportunities for independent directors, including Mutual Fund Directors Forum, the Investment Company Institute, and industry news publications, to provide guidance on how best to obtain information about these practices and what to do with the information once it is received.
Again, I commend the staff on the work that it is doing to address the mutual fund governance and compliance issues. I believe the collaborative effort among Congress, the SEC and other regulatory and enforcement agencies, and the industry, including input from independent directors, which is currently underway, will go far in addressing the current misadventures and preventing future ones.
Leslie L. Ogg