March 10, 2004
Mr. Jonathan G. Katz
Re: File No. S7-03-04; Proposed Rule: Investment Company Governance
Dear Mr. Katz:
Morningstar, Inc. ("Morningstar") is pleased to provide comments on the Securities and Exchange Commission's (the "Commission") proposed rule, Investment Company Governance (the "proposal"). This proposal would amend rules under the Investment Company Act of 1940 to require registered investment companies ("funds") to adopt certain governance practices.
Overall, we support the proposal, which should be beneficial in restoring the system of checks and balances that is essential to ensuring that the interests of fund shareholders are represented. Even with regulation by the Commission, much of the burden of fund oversight falls to the funds themselves, particularly to the fund directors. However, as recent events have shown, fund directors have too often failed to represent shareholders with the necessary vigor and objectivity. The proposal's aim to increase director visibility and accountability is laudable and should empower directors to serve as a more effective check on fund management.
Thank you again for the opportunity to express our views regarding this important proposal. We offer the following specific comments:
We do not oppose the proposed requirement that independent directors constitute at least 75% of a fund's board. However, we believe the Commission should consider such a requirement in conjunction with the proposed requirement that fund boards be headed by an independent chairman. That is, if the Commission requires fund boards to be chaired by a non-interested party--a proposal we wholeheartedly support--we believe that a requirement that independent directors constitute the simple majority of a board should suffice. On the other hand, if the Commission elects not to adopt its independent chairman proposal, we believe that the 75% requirement will promote the spirit of independence that has been sorely lacking.
Independent Chairman of the Board
Don Phillips, who is a managing director of Morningstar, put the case for independent fund board chairmen aptly in his recent testimony before Congress. As Don noted, the chairman and CEO are often the same person in U.S. operating companies. However, such an arrangement presents a conflict of interest in funds that does not exist in operating companies. In an operating company, there is only one party to which directors, be they independent or not, owe their loyalty--the firm's stockholders. In a mutual fund there are two parties to which the non-independent directors owe their allegiance--one is the fund shareholder, the other the stockholder in the fund management company. Only independent fund directors have a singular fiduciary responsibility to fund shareholders. Accordingly, we believe that fund shareholders are better served when an independent chairman oversees their fund. Thus, we heartily support the Commission's proposal.
We acknowledge that our view is not shared by a vocal contingent of critics. Indeed, some have described this proposed requirement as "dangerous." Others have dismissed it as a superficial fix, pointing out that independent chairmen have been no more successful in thwarting recent abuses than their interested counterparts. And still others have argued that the chairman's critical duty in setting the board's agenda and leading the sometimes nuanced discussion of fund operations simply couldn't be carried out effectively by an independent party.
We respectfully disagree on all counts. To be sure, the proposal is a clear threat. But the real question is to whom. The fund shareholder, as critics allege? Or the industry status quo? Fund fees remain stubbornly high considering the explosive growth that the industry has enjoyed in the last two decades. Also perplexing are the numerous instances in which funds have imposed a significantly higher management fee on retail investors than on institutional clients. This despite the fact that the adviser renders virtually identical services to each type of shareholder. What explains these curious phenomena, which persist despite the tremendous operating leverage that asset managers enjoy?
We believe the answer is simple, if unappealing to the industry's staunch defenders: In general, fund boards have been lax in conducting negotiations with the fund's adviser concerning the fees charged retail investors for professional management. Famed investor Warren Buffett once memorably quipped that, "Negotiating with one's self seldom produces a barroom brawl." While Mr. Buffett was referring to CEO stock options, the principle he describes extends to the fund boardroom as well. Absent the spirit of independence that's critical to ensuring any arm's length negotiation, fund boards have acted not like the overseers envisioned by the Investment Act, but rather like a superfluous appendage of the fund's adviser.
Fund boards have also fallen woefully short in redressing deficient performance. In fact, we can count on one hand the number of instances in which a fund's board has stood up to the adviser and said, in essence, "you're fired." This is a critical and unjustifiable failure of shareholders that must be righted. The Commission's proposal would help to restore accountability and oversight in an essential way: Establishing independent leadership of the board.
To be sure, independent chairmen will not cure all ills. Objective, rigorous oversight is a responsibility shared by the entire board. However, the strenuous objections of opponents to this proposal--premised on the notion that the chairman's role is far too important to be entrusted to an outsider lacking the requisite knowledge of the fund company's operations-are merely attempts to distract from the clear intent of the Investment Act. That act unambiguously vests the board with responsibility for representing the fund shareholder, not safeguarding the interests of the fund's adviser. We are confident that an independent chairperson, when working in concert with interested directors and other fund company personnel, would provide informed leadership of the board without unjustly harming the interests of the adviser.
Finally, we do not support alternatives that would create a countervailing independent board structure insofar as these measures would serve in lieu of the Commission's board composition and/or independent chairman proposals. In our opinion, the overarching goal should be to increase the independence of the board. While separate meetings of independent directors certainly provide a forum for unfettered discussion, such a measure seems to be aimed at insulating the board from pressures that ideally shouldn't exist in the first place. That is, if the board is doing its job as an unbiased representative of shareholder interests, independent board members shouldn't have to seek alternate means of expressing their views. That said, we're unopposed to the Commission's proposed requirement that independent directors meet separately on a quarterly basis provided it supplements, rather than substitutes for, the independent chairman proposal.
We support the proposal requiring directors to perform an evaluation, at least once annually, concerning effectiveness of board and its committees. However, we believe that the Commission should consider ways in which it can provide specific, actionable guidance that fund boards can use when performing a self-assessment. Namely, the Commission should specify the factors and criteria that a board member should use when making such an evaluation. For example, should each board member prepare a list of goals, expectations, or benchmarks against which their performance is assessed?
We also strongly urge the Commission to consider requiring public disclosure of director self-assessments. These disclosures could accompany the disclosures proposed by the Commission in its recent release, Disclosure Regarding Approval of Investment Advisory Contracts by Directors of Investment Companies.
We concur with the Commission's conclusion that it is difficult, if not impossible, to set a limit on the number of funds that a board member can effectively oversee. That said, the Commission should consider requiring board members overseeing more than 30 funds to explain how they are able to uphold the fiduciary duty owed to shareholders in their self-assessments. This explanation should include an approximation of how much time the board member allots to reviewing the operations and performance of each fund under his/her oversight. While a 30 fund disclosure threshold will strike some as arbitrary, we believe it is a reasonable limit considering the depth and breadth of directors' responsibilities.
Separate Meetings of Independent Directors
As stated previously, we do not oppose the Commission's proposal that independent directors meet separately on a quarterly basis.
Hiring Independent Staff
We support the Commission's proposal to explicitly authorize fund directors to hire independent staff to assist the directors in upholding their fiduciary duties. We believe that independent staff should be employed by the fund, not its advisor. This structure will serve to minimize conflicts that might otherwise arise and better align the staff's interests with those of fund shareholders.
That said, we are not in favor of a proposal requiring fund directors to hire independent staff. Such a requirement could prove onerous to smaller funds that lack the scale needed to absorb the incremental expenses without negatively impacting their ability to compete (as such costs could drive up the fund's expense ratio, making it more difficult to compete). While the proposal raises the possibility of exempting smaller funds from such a requirement, we believe such an approach is misguided. Directors' responsibilities do not diminish with the size of the charges they oversee.
In our opinion, a more workable approach would tie the need for additional, independent staffing to the number of funds overseen by fund directors. For example, if a board oversaw 50 or more funds on average without the assistance of independent staff, perhaps the chairman should be required to disclose (a) whether any board members requested the help of supplemental staff and, if so, (b) why the request was denied, and (c) what factors contribute to directors' ability to effectively cover so many funds. This disclosure could be included in the annual letter to shareholders currently contemplated by the Commission's proposal, Disclosure Regarding Approval of Investment Advisory Contracts by Directors of Investment Companies.
Record Keeping Requirement
We support the proposed requirement. In fact, it is surprising that fund boards have not reliably archived such materials given their importance in gauging the competence and diligence with which directors have overseen the fund's affairs.
Other Matters for the Commission's Consideration
In addition to the requirements outlined in the proposal, we submit the following other proposals for the Commission's consideration:
To remedy this situation, Morningstar suggests that each fund prospectus begin with an explanation of the fund's corporate structure, such as the following:
When you buy shares in a mutual fund, you become a shareholder in an investment company. As an owner, you have certain rights and protections, chief among them an independent board of directors, whose main role is to represent your interests. If you have comments or concerns about your investment, you may direct them to the board in the following ways...
The question is how to measure what is commensurate with a board member's standing as a fiduciary. In our opinion, that threshold is reached when at least one half of each director's annual compensation is paid in the form of fund shares. In order to ensure that directors remain sufficiently invested in the charges they oversee, the Commission should strongly consider limiting directors' ability to sell compensatory fund shares for a specified period following the grant date. Given the prudence of promoting oversight practices that are focused on achieving long-term objectives , we believe that a three-year lock-up period is appropriate.
In addition, the Commission should consider adopting a requirement that the value of each director's aggregate fund holdings equal or exceed his/her annual cash compensation for serving on the board.