I am pleased to submit this comment letter concerning mutual fund governance on my own behalf, and not on behalf of my law firm or any client.
I have great sympathy with the Commission's desire for reform in the mutual fund industry. I also have sympathy for the Commission's desire, stated with admirable frankness by Chairman Donaldson in his recent testimony before the Senate Banking Committee, to avoid any congressional legislation on mutual fund issues and to adopt all mutual fund reforms solely by regulation.
However, the Commission remains a creation of statute, and is bound by the statutes Congress has passed. Section 10 of the Investment Company expresses Congress policy concerning mutual fund governance. Section 10 grants a mutual fund the right to have up to 60 percent of its directors be non-independent (50 percent for certain investment companies affiliated with other financial services firms). It is flatly inconsistent with the clear language of the statute for the Commission to require that 75 percent of the directors be independent, or that the board chair be independent. (I express no opinion on the wisdom of the proposal as a policy matter, although I do note the absolute lack of empirical evidence cited by the Commission that these governance changes would in fact better protect mutual fund shareholders.)
I am fully aware that the Commission has phrased its proposed rules in terms of a condition for application of commonly-used exemptive orders and rules, rather than as an across-the-board requirement for all mutual funds. However, this expedient does not solve the Commissions authority problem (an issue it incidentally fails to address at all in the proposing release). The Administrative Procedure Act invalidates an agency rule if it is arbitrary, capricious, or contrary to law. An agency rule applying a standard that is flatly inconsistent with the statutory standard set forth for that specific issue is a classic example of a standard that is contrary to law. The Supreme Court's recent decision in General Dynamics Land Systems, Inc. v. Cline (Feb. 24, 2004), is only one of a variety of judicial decisions invalidating agency rules as contrary to the express language of the applicable statute. The Commission is entitled to deference on many issues -- but not on an issue where Congress has spoken directly, clearly and to the contrary to the precise matter at issue. For the Commission to decline to grant an investment company an exemptive order, or the benefit of a rule, because of conduct that is expressly permitted by the statute, would be without question an action that is contrary to law. Such an action should and would be struck down by the courts. (Other aspects of the Commissions proposal, such as requiring the independent board members to meet separately and giving them the authority to hire staff, are more procedural in nature and do not directly conflict with the statute, and therefore likely would be held to be within the Commissions discretion.)
I recognize that the Commission has already gone down this path before. In 2001, the Commission purported to change the requirement from 40 percent independence to 50 percent independence for application of many of these same exemptive provisions and rules. The mutual fund industry accepted this change with good grace, and not a single fund company challenged the Commission's action in court at that time. Nonetheless, no court has blessed the Commission's purported precedent. The Commission's proposed actions here, changing the standard for independence to 75 percent and requiring an independent chair, takes the Commission even further from the applicable statutory provisions. The fund industry should not (and likely will not) be as forgiving of the Commission's encroachment as it was in 2001.
I am also fully aware that senior members of several of the congressional committees with oversight of the Commission have endorsed this proposal. However, it is the cardinal principle of American jurisprudence that we are a government of laws, not of men. We have a statute, the Investment Company Act of 1940, which expressly permits mutual funds to have certain board structures. If the Commission believes those structures are no longer in the public interest, it should go to Congress, make its case, and attempt to persuade Congress to change the relevant statute (and persuade Congress to avoid statutory changes currently under consideration which the Commission does not support). And if the relevant congressional committee chairs and ranking members wish to see new mutual fund board structures different from those currently permitted by law, they should bestir themselves and amend Section 10. But the Commission does not have the ability to amend duly enacted congressional legislation. The expedient of adopting limitations on exemptive orders and rules that are flatly inconsistent with the express provisions of the Investment Company Act itself does not avoid this principle.
The Commission properly insists that its regulated industries follow the law with care and precision. This proposal is one in a troubling pattern in which the Commission appears not to view itself as similarly bound to follow the law. The Commission should exercise at least as much care to ensure that it follows the federal securities laws, and the laws governing action by administrative agencies, as it makes to ensure that the industries it regulates follow the law. The Commission's proposal is contrary to law. The commissioners, who have sworn to uphold the law (even the parts with which they may disagree as a policy matter), should not adopt this proposal.