March 9, 2004
Via E-mail: email@example.com
Mr. Jonathan G. Katz,
Re: Proposed Rule Relating to Mandatory Independence Requirements For Boards under the Investment Company Act of 1940
Dear Mr. Katz:
We are pleased to respond to Release No. IC-26323 (the "Proposing Release") in which the Securities and Exchange Commission (the "Commission") solicited comments on proposals to amend certain rules under the Investment Company Act of 1940 (the "Act"). The proposed amendments would require registered investment companies and their affiliated persons that rely on certain exemptive provisions under the Act ("funds") to comply with certain governance practices, including that the chairmen of fund boards be independent and that seventy-five percent of the board be composed of independent directors (together, the "independence requirements").
We believe that the Commission overestimates the potential for fund boards to eliminate the kinds of legal and compliance problems which have come to light since September 3, 2003. Fund boards do not and cannot exercise supervisory authority over the business and management of the firms that manage fund assets, distribute and market fund shares and/or provide other necessary services to funds, including their employment policies, compensation incentives and available business opportunities. Fund boards and independent directors have limited ability, and only through the adoption and oversight of certain policies and procedures, over compliance with applicable law and regulation by those firms.
We believe that there is no reasonable basis for mandating that fund chairmen be independent directors based on the experience of funds both before and after September 3, 2003. In addition, when thoroughly debated in connection with the passage of the Sarbanes-Oxley Act and the rules of national securities exchanges, such a requirement was not adopted. As a result, and notwithstanding the high regard we have for the independent chairmen with which we work, we believe that there is no clear benefit and that there may be substantial detriment to actual corporate governance from such a requirement. Moreover, we believe there is a serious risk that the Commission's approach of highlighting and amplifying the role of independent directors may create a false sense of confidence among shareholders and investors that fund problems are "solved", when there is at best a tenuous relationship between those problems and their causes, on the one hand, and the independence of fund directors, on the other. At the same time, we do not believe that boards composed of a majority of independent directors lack any of the power or authority necessary to address the potential and actual conflicts of interest that arise between the funds and their advisers.
I. Independent Chairman
The Commission has proposed to amend certain of the exemptive rules under the Act to require, as a condition to reliance on the rule, that the chairman of the fund board be an independent director.1 In the Commission's open meeting on January 14, 2004 (the "Open Meeting"), the Division of Investment Management reported that approximately eighty percent of fund boards have an officer of their adviser who serves as chairman. We believe this practice reflects the importance that shareholders, investors and board members accord to the identity and expertise of the investment adviser. We do not believe, as some statements in Commission releases suggest, that the widespread practice is evidence alone, or evidence at all, that boards are "dominated" by their advisers or senior officers and we are not aware of evidence to that effect.
Fund board governance cannot be divorced from board governance of public company issuers more generally. In that connection, we point out that neither Congress nor the national securities exchanges have mandated independent chairmen notwithstanding the wide ranging and well publicized debates on that question preceding and following the adoption of the Sarbanes-Oxley Act.
Accordingly, in light of the longstanding and broadly followed practice, the absence of evidence that domination is a widespread condition within fund boards and the determinations by Congress and the national securities exchanges not to mandate independent directors as part of their thorough examination and revision of board governance practices, we believe that there is a heavy burden on the Commission to demonstrate convincingly that (1) harm to funds has arisen from current practice and (2) benefits will follow from the proposed change, such as improved fund performance, or lower fees and expenses. Based on the anecdotal evidence offered by the Commission to date, we do not believe that the burden has been met on either issue.
1. There is an absence of evidence.
In the Proposing Release, the Commission considers a number of empirical studies that attempt to analyze the performance of funds and the independence of fund boards. However, none of these studies establishes any firm correlation between fund performance, lower fees, and independent chairmen of fund boards, and, in fact, the authors of these studies warn against concluding that a correlation between director independence and fund performance exists.2 While the Commission suggests that lower advisory and other fees may result, since there is no demonstrable correlation now, we are not convinced that any such correlation will result.
As noted by Commissioner Glassman during the Open Meeting, recent investigations and enforcement actions by the Commission have embroiled many fund complexes that currently comply with the proposed independence requirements. Commissioner Glassman also stated that the historic correlation between independent chairmen and any affirmative benefits to funds is an area where the Commission could gather more evidence. Commissioner Paul Atkins has also expressed reservations over whether the independence requirements are "an appropriate or necessary step."3 We strongly urge the Commission to obtain such evidence before imposing such a sweeping change, particularly in light of the impact on governance of the Commission's recent rules, such as rule 38a-1, and proposed rules directly addressing the problems experienced in the mutual fund industry.
2. Fund governance may not be strengthened and may be less effective.
As the Commission staff reported, the overwhelming majority of fund boards today have chairmen who are executives of the fund adviser. As an executive of the adviser, the chairman provides invaluable expertise, brings great understanding to a board in making decisions, and can effectively lead the board through a discussion of a detailed and, in some respects, complex agenda. An independent chairman, on the other hand, must rely on the knowledge of interested directors and other executives of the adviser and must set the agenda and priorities for the fund board without the benefit of having a fund company executive's expertise. In addition, an independent chairman may require independent staff with the requisite expertise. We believe that requiring that funds have an independent chairman could result in a considerable loss of efficiency and competency.4
We note that in the release adopting Rule 38a-1 the Commission expressed a strong preference for the independent compliance officer function to be performed by an employee of the adviser who is under the control of the independent directors. The Commission was concerned that a compliance officer employed by the fund rather than the adviser would be less effective because he or she would be out of the day-to-day flow of information important to the compliance functions. We suggest that this same reasoning also applies to the independence of the chairman of the board. Independent directors may choose to avail themselves of this first-hand knowledge and the belief that they can adequately carry out their duties more effectively with the benefit of the access to information and expertise provided by a chairman who is a senior executive of the adviser. We believe that this judgmental decision, which will vary with facts and circumstances, should not be made by regulatory fiat.
The Commission acknowledges the problem associated with having a lack of expertise and has proposed in the Release to make available independent director staff. We have never thought fund boards lacked the authority to engage consultants, advisers or staff for whatever purpose they believe appropriate or necessary. However, in our experience, those boards with independent chairmen rely to a very considerable extent on counsel to the independent directors for assistance in understanding fund issues. Lawyers' experience, however, is necessarily limited and ordinarily does not extend in an informed way into the commercial and financial aspects of the fund business necessary, in our view, to fully support an independent chairman. Notwithstanding that some fund complexes with longstanding independent chairmen or "lead directors" have an appropriate infrastructure for supporting the function (and without commenting on whether such arrangements have enabled such fund complexes to avoid the current problems), we believe that mandating an independent chairman will effectively mandate the retention of an independent staff and/or enhanced participation by independent counsel in fund complexes both large and small.
Creating the necessary and desirable infrastructure would result in an increase in fixed expenses for funds required to retain such staff and counsel, but it is doubtful that funds would receive a commensurate improvement in the quality of advice they receive. Indeed, it is unclear whether independent staff would be able to give the same quality of advice as does a chairman who is an executive of the adviser. As stated above, an executive chairman brings on-going and in depth knowledge of and access to business developments and issues that cannot be duplicated with the greatest of will by an independent chairman and staff's second hand knowledge. An executive chairman also has the direct ability to implement actions by the board or in response to the independent directors.
For all these reasons, we believe that adopting a requirement that prevents a fund chairman from also being an executive of the adviser not only would fail to provide any clear benefit to shareholders but could be contrary to their interests.
3. Independent directors may not be willing and able to serve.
We also believe that many prospective independent chairmen will, correctly, perceive the position as creating responsibility without authority, especially because neither the fund chairman nor the independent directors have any authority in respect of the management company. This bifurcation does not exist for non-independent chairman. The time commitments and concerns about actual or perceived risks of personal liability may also impact the willingness of independent directors to take on the responsibilities of chairman.
4. Requiring an independent chairman may worsen boardroom culture.
We believe that boards may become polarized as independence requirements alter the dynamics of director relationships. Excessive reliance upon independent staff may also create an unhealthy adversarial relationship among board members and between independent directors and the adviser.5
5. Certain alternatives may serve the same purpose more effectively.
We believe that the idea of appointing a lead director to serve as a spokesperson for the independent directors may have sufficient merit to consider on an experimental or limited basis. When combined with the proposed separate sessions of independent directors, the position has the potential to address silence amongst independent directors while creating a suitable institutional role. This may foster confidence among independent directors and the expectation of direct and pointed interventions by independent directors. We do not believe, however, that until the idea has proven its worth, it should be mandated. Many independent directors are unwilling to accept the diminution of their access to and relationship with the fund management company implicit in the designation of someone else as "lead director." These directors do not believe that lead director governance models are desirable models for public company board governance. These directors are not clearly wrong in the absence of evidence to the contrary.
II. Board Composition
The Commission proposes to require that at least seventy-five percent of fund boards be independent. The drafters of the Act originally proposed a mandatory simple majority of independent directors. However they were persuaded by the argument, endorsed by then Chief Counsel of the Commission's Investment Trust Study, David Schenker, that to do so would allow the board to repudiate consistently the management advice that the shareholders chose to purchase.6 Believing some check was necessary on the influence of management, the forty percent requirement was adopted. In 2001, this requirement was increased to a simple majority, without substantial opposition, in large measure because most large fund complexes already had a majority of independent directors.7
Requiring that at least seventy-five percent of the members of fund boards be independent is notably different from the independent chairman requirement, since in the former case, nearly sixty percent of investment companies have voluntarily chosen to have this super-majority of independent directors. Nonetheless, in light of existing provisions in the Act and various rules thereunder requiring that the most important and conflict-laden actions be taken both by a majority of all directors and by a majority of independent directors, we believe that there is no significant positive benefit (at the risk of providing a false sense of confidence) from an increase to a 75% requirement. We also think it would be particularly unfortunate to visit upon funds whose boards have historically met the 75% requirement the expense of shareholder meetings when through resignation or retirement the requirement is not met.
Boards do not in fact lack the powers the Commission seeks to give to them. Indeed, boards are increasingly exercising their power and are likely to do so in view of the concerns raised by recent compliance problems and rules recently adopted by the Commission. We believe that the balance of considerations favors postponing an increase in the percentage of independent directors until some evidence supports a distinction between those boards with 75% or more independent directors and those with a "mere" majority.
III. The Commission's Other Proposals
In our practice, independent directors routinely hold executive sessions not involving interested persons, while some, but not all, boards have made self-evaluations and most boards have at least considered making such self-evaluations. We believe that these are certainly best practices but that a variety of governance practices have in fact stood the test of both the commercial marketplace and the regulatory environment. As a result, we believe that the practice of holding executive sessions and performing self-evaluations should be left to the discretion of fund directors and not mandated by Commission rules. In addition, since we do not believe that boards lack the authority to hire independent staff, we believe that it is not necessary to provide for it by rule.
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We appreciate the opportunity to comment on the proposed rules, and we would be pleased to discuss any questions the SEC or its staff may have about this letter. Any questions about this letter may be directed to John E. Baumgardner, Jr. (212-558-3866).