The Independent Directors of Merrill Lynch Cluster A Funds
c/o Merrill Lynch Cluster A Funds
800 Scudders Mill Road
Plainsboro, New Jersey 08536
January 27, 2000
Jonathan G. Katz, Secretary
U.S. Securities and Exchange Commission
450 5th Street, N.W.
Mail Stop 6-9
Washington, DC 20549
Re: Role of Independent Directors of Investment Companies
File No. S7-23-99
Dear Mr. Katz:
We are the independent directors of sixteen investment companies that are advised by Merrill Lynch Asset Management Group and its affiliates ("Merrill Lynch") and are known as the Cluster A Funds. As individuals our experience as Cluster A directors ranges from three months to more than twenty years. We are writing to express our views with respect to the above-referenced proposed rulemaking under the Investment Company Act of 1940, as amended (the "1940 Act"), as we believe we offer the benefits of a diversity of views and considerable practical experience. Our sensitivity to governance issues has been sharpened by the participation of Cluster A directors in some of the earliest and most important developments in the mutual fund industry. Our involvement in shaping management's policies with respect to the funds and in protecting investors is reflected in the Gartenberg v. Merrill Lynch Asset Management, Inc.1 judicial decision. In that case, the independent directors of one of the ClusterA Funds were held to have satisfactorily fulfilled their obligations to the funds and shareholders in approving management's fees.
For over twenty years, the Commission has looked increasingly to the independent directors to assume more responsibility for monitoring fund operations, and greater attention has been given recently to our governance role by both the Chairman and the staff of the Commission, culminating in the proposed rule amendments. We respect the Commission for focusing its attention on the role of independent directors in mutual fund governance and appreciate the Commission's interest in our views on the proposals. The Commission's proposal to require a majority of independent directors and its support for the retention of independent counsel for the independent directors would standardize for virtually all funds the position we have taken for many years in the Cluster A Funds. We support those suggestions and believe they will enhance fund governance for others as they have for us. We are concerned, however, that in certain respects the proposals are too restrictive. We are submitting this letter to comment on four aspects of the proposed rulemaking. We have addressed each issue in the order in which it appears in the Commission's release proposing the rule amendments. In summary, our views are as follows:
Set forth below is a more detailed discussion of our comments on the proposed rulemaking.
We view many of the Commission's proposals as a codification of practices that, as independent directors of the Cluster A Funds, we already observe as a matter of routine. For instance, the composition of our board has long met the standard that a majority of a fund's board be comprised of independent directors. In fact, we represent five of the seven members of the boards on which we serve, which is in excess of a two-thirds supermajority as well. For years, each of our boards also has had a committee, consisting of only independent directors, that makes recommendations to the full board and shareholders as to new independent directors. We are represented by independent counsel who represents our interests as independent directors, separate from counsel for the fund or the adviser. These practices have helped to ensure our strong and active role in fulfilling our mandate under the 1940 Act. We therefore support the Commission's proposed amendments in this regard.
We would caution, however, against requiring a two-thirds majority of independent directors. While we generally favor a supermajority of independent directors in practice, we recognize that a majority of independent directors achieves the same protective goals as does a supermajority. Further, there are often practical difficulties surrounding the replacement of independent directors who leave the board's service unexpectedly. This is especially true for smaller boards where the resignation or death of one director could cause the remaining independent directors to fall below a supermajority. We believe it would be unwise to sacrifice the advantages of a small board just to ensure that an unexpected resignation would not cause a board to fail to meet a supermajority requirement. We believe that a rule requiring a simple majority of independent directors, together with general yet voluntary adherence to the Investment Company Institute's "best practices" recommendation of a supermajority, would best serve the mutual fund industry. It also would render less burdensome the proposed time period for reconstituting fund boards to have a majority of independent directors, since it would be less likely invoked. Nevertheless, in the event the new rulemaking would require the selection of additional independent directors, we suggest the Commission adopt a longer time period than that proposed in order to allow board nominating committees to make unhurried, well-deliberated selections.
The independent directors of the Cluster A Funds have always been represented by qualified legal counsel who is separate, and in our view independent, from fund counsel or counsel for management. Having separate counsel has served us well over the years. The Investment Company Institute has identified the representation of the independent directors by their own counsel as a recommended "best practice" of board governance, a measure we have long supported. We urge caution, however, in the Commission's approach toward imposing regulatory requirements with respect to selection of legal counsel. Independent directors have a profound and obvious self interest in obtaining independent as well as competent counsel to guide them in fulfilling their fiduciary duties. The Commission has not set forth any examples of abuses regarding the selection of or advice given by independent counsel for independent directors. Thus we consider the Commission's proposal to define independence as an attempt to solve a problem that does not exist.
We are alarmed at the prospect of the Commission requiring us to terminate our relationship with our current counsel and, had the Commission proposals been in force, to have terminated each of our predecessor counsels, the advice and guidance of whom we have enjoyed for over 20 years. We understand we would be required to do just that if the current proposal is adopted since the Cluster A Funds will continue to rely on various exemptive rules such as Rule 12b-1. While we acknowledge the Commission's concern for protecting the interests of independent directors, we firmly believe that we are in the best position to make judgments concerning the qualifications and independence of our counsel. We are the ones who are familiar with fund management and other facts and circumstances relating to the funds we serve. We also meet the rigid guidelines currently in place in order for a director to qualify as an independent director. This is one of the fundamental cornerstones of the 1940 Act designed to ensure that independent directors are in a position to look out for and protect the interests of fund shareholders. Just as we are deemed by law capable of evaluating the appropriateness of contracts with fund management and other areas where potential conflicts of interest exist, we are capable of being, and should be, the final arbiters of whom we select as counsel to represent us.
The Commission should not overlook the relationship between the independent directors and the individual acting as counsel. As independent directors, we are faced with significant responsibilities in our oversight of a fund and often feel the need to consult with counsel we know and trust. We hire a person, not an entire firm, to provide us with the advice we need. At the same time we keep ourselves informed about the firm's dealings with the management company or its affiliates to assure ourselves that there are no conflicts of interest that we believe could impair our counsel's ability to render the advice we need. As directors, we would feel particularly deprived of our ability to rely on an individual lawyer with whom we have developed strong bonds should the Commission deem him or her as unqualified due to his or herfirm's activities.
The individuals we have selected over the years to represent us are or were members of law firms that have vast experience in dealing with or representing large global financial services firms. To us, this type of experience is invaluable. A lawyer who is well versed in the financial services industry, generally and specifically in asset management, is more capable of protecting us and representing our interests and the interests of fund shareholders. We are concerned that the Commission's regulatory proposal, if adopted, would drastically shrink the available pool of experienced counsel by rendering as unqualified individuals who are members of firms that may represent, or have represented, affiliates of fund management. Such representations may have had little, if anything, to do with the financial service company's advisory activities. Furthermore, the proposed rulemaking could even result in otherwise qualified individuals declining to represent us due to the fear that such representation could prevent future and potentially more lucrative client development opportunities by other practice groups of such attorneys' firms.
Qualification as an Independent Director
We would like to express our support for proposed Rule 2a19-3 under the 1940 Act. The proposed rule would conditionally exempt an individual from being disqualified as an independent director simply because of ownership through investment in an index fund of a security issued by a fund's adviser or underwriter or their controlling persons. In general, ownership of shares of an investment company represents a passive form of investing. This is especially true in the case of an index fund where by definition the selection of securities is a mechanical exercise and neither a director nor anyone else has the ability to influence the selection of investments. While we note that the 5 percent threshold afforded by the proposed rule likely would not pose an actual barrier in most instances, the very nature of an index fund makes such a limitation unnecessary, regardless of the percentage a security represents in an index. We therefore propose that the Commission clarify that a director's ownership of shares of any index fund does not compromise his or her independence, provided that the fund is tied to a market index that is calculated in accordance with objective standards. It is also unnecessarily burdensome to prevent independent directors from using one of the most important investment vehicles available to investors.
While we understand the necessity of disclosing certain information about the independent directors to prospective and current investors, we have very great concern over the Commission's proposed amendments with respect to disclosure of director information. Upon recently amending Form N-1A, the Commission articulated a desire that funds disclose onlyinformation that would be meaningful to investors. Practically speaking, we strongly doubt that investors would decide whether to invest in a fund based on the proposed new information about the fund's directors. It is clear to us that the directors' privacy concerns and the practical considerations of obtaining and disclosing much of the information requested outweigh any benefit to investors.
More specifically, we do not believe it is appropriate to disclose security ownership for the past five years of directors and their immediate family members. We do not object, however, to disclosing a director's current aggregate beneficial ownership and the dollar value of shares of all funds of which he or she is a director that are managed by the same investment adviser. Beneficial ownership should be limited to the holdings of the director, the director's spouse and any other dependents living in the same household.
The proposed amendments requiring disclosure with respect to positions, interests, transactions and relationships of directors and their immediate family members are inordinately burdensome to directors. They also go well beyond the disclosure requirements of Regulation S-K which certainly to date have dealt adequately with disclosure regarding potential conflicts of interest for directors and officers of operating companies. In addition, the proposed amendments impose upon a director a due diligence obligation beyond his or her ability to fulfill. A director may be obligated to disclose information about a sibling, in-law, etc., that he or she simply is unable to obtain. Disclosure (or non-disclosure, as the case may be) of information about a potential conflict of interest additionally sets up the director as a target for potential disclosure liability under the Securities Act of 1933, as amended (the "1933 Act"). Further, as with the issues above, we do not believe that investors would rely on this information in making an investment decision about a fund. To the extent that the Commission nevertheless decides that disclosure of potential conflicts of interest from transactions or positions of family members should be required, we recommend that the Commission limit the family members concerned to the director's spouse and dependent members of the director's household.
We also oppose the Commission's proposal to require, beyond already applicable requirements, disclosure of potential conflicts of interest among the independent directors. Under the 1940 Act, a fund director either is interested or non-interested. Disclosure of which directors are interested already is required. The proposed amendments would suggest that certain independent directors may be "sort of" interested, thereby muddying their non-interested status and creating confusion, whereas disclosure policy usually is intended to clarify.
While we believe the information called for by the proposals may be useful to determine compliance with regulatory requirements, we doubt that it is information shareholders or potential investors would consider to be material. Rather than assisting investors in deciding whether to invest, such information likely would be of greater utility to the Commission inattempting to determine whether, pursuant to Section 2(a)(19)(A)(vi), to issue an order designating a director as interested due to a material business or professional relationship. The Commission could achieve its objective by instead requiring such information to be retained by funds.
Finally, we also oppose any requirement to disclose in a fund's statement of additional information the board of directors' bases for approving the investment advisory contract. As with the other disclosure issues discussed herein, we do not believe that investors would consider the reasons for board approval of an advisory contract to be a material factor in deciding whether or not to invest in a fund. To add that disclosure is also inconsistent with the recent amendments to Form N-1A which were designed in large part to identify information of material relevance to investors considering an investment in a fund and eliminate other information. Additionally, absent such requirement, all directors, independent or otherwise, already are subject to standards of care imposed by Section 36(b) of the 1940 Act and state corporation law with respect to the contract approval. The reasons for a contract's approval already are generally noted in minutes of board meetings. We are concerned, however, that disclosing the bases for approval of an advisory contract in an offering document would only serve shareholder plaintiffs by targeting directors with possible 1933 Act liability in addition to any 1940 Act or state corporation law liability that might otherwise apply.
In closing, while we generally support the Commission's proposed rule amendments with respect to board governance issues, we also must acknowledge that current regulatory requirements, together with our adherence to practices that are consistent with the Investment Company Institute's "best practices," have served us and the fund shareholders under our oversight well. We agree with the Commission that independent directors need to protect, and have protected, investment companies and their shareholders from the conflicts of interest in the fund industry. Continuation of such practices can only strengthen the protective function independent directors provide the fund industry. We therefore request that the Commission fully consider which current practices and rules already best achieve the board governance goals of the 1940 Act and exercise restraint in imposing additional regulatory requirements.
Please feel free to call M. Colyer Crum at 781-239-1519 if you would like to discuss any of our comments.
The Independent Directors of the Merrill Lynch Cluster A Funds:
M. Colyer Crum
Laurie Simon Hodrick
Jack B. Sunderland
J. Thomas Touchton
Fred G. Weiss
By: /s/ M. Colyer Crum
M. Colyer Crum
Chairman, Audit Committees of the Merrill
Lynch Cluster A Funds
cc: The Honorable Arthur Levitt, Chairman
The Honorable Paul P. Carey, Commissioner
The Honorable Isaac R. Hunt, Commissioner
The Honorable Norman S. Johnson, Commissioner
The Honorable Laura S. Unger, Commissioner
Paul Roye, Director, Division of Investment Management
-- 694 F.2d 923 (2d Cir. 1982), cert. denied, 461 U.S. 906 (1983). Similar findings were made in Krinsk v. Fund Asset Management, Inc., a later decision involving another Merrill Lynchfund. 875 F.2d 404 (2d Cir. 1989).