January 28, 2000
Mr. Jonathan G. Katz
Re: Request for Comments on Proposed Rules Concerning the Role of Independent Directors of Investment Companies -- File No. S7-23-99
Dear Mr. Katz:
The Investment Management Practice Group of Dechert Price & Rhoads is pleased to have this opportunity to comment on the Commission's proposed rules "to enhance the independence and effectiveness of fund boards of directors and provide investors with greater information about fund directors," as set forth in Release No. IC-24082 dated October 14, 1999.
Dechert Price & Rhoads is an international law firm with a wide-ranging investment management practice that serves clients in the United States and worldwide. Among these are many U.S.-registered open-end and closed-end funds, boards of directors and independent directors. In developing these comments, we have drawn on our own long-time experience with fund governance matters, and have been most mindful of the interests of fund shareholders. In response to the Commission's request for comments, we have discussed the Commission's proposals extensively with our clients. We also convened forums in New York and Los Angeles earlier this month that were attended by a diverse group of clients and friends of the firm. The forums provided independent directors and others who are concerned day-to-day with fund governance an opportunity to discuss in detail the Commission's pending rule proposals. Although the comments that follow have been very usefully informed by the perspectives shared in this process, they reflect our own views and not necessarily those of any client of the firm.
In general, we applaud the Commission's efforts, through its proposed rulemaking as well as the Roundtable on the Role of Independent Investment Company Directors convened by Chairman Levitt in February 1999, to identify ways of improving mutual fund governance practices. Mutual funds have become one of the nation's most popular and successful financial intermediaries in important part because of the unique system of governance to which they are subject. In the sixty years since adoption of the Investment Company Act of 1940 ("Act"), changes in law and regulations on fund governance and evolving industry practices have served to protect the interests of shareholders while accommodating rapid industry growth. The Commission's recent proposals represent a significant new milestone in this process.
We strongly share the Commission's view that maintaining the public's confidence in mutual fund investing requires effective fund boards. Current requirements have worked well for this purpose, in that they have set forth strong minimum standards while permitting different approaches and innovation. It is noteworthy that governance arrangements common to a large majority of U.S. mutual funds in fact exceed the minimum requirements of the Act in key areas such as board composition. Nonetheless, we do support changes in the rules, including many aspects of the recent proposals, where appropriate to strengthen board functioning even further.
Our specific comments on the proposed rules address the following matters: first, certain of the governance requirements that are proposed as new conditions for the availability to funds of key exemptive rules; and second, aspects of the proposed new disclosure requirements about fund directors. We address these in turn below.
I. Conditions of Exemptive Rules
The Commission proposes to condition the availability of ten key exemptive rules on funds adopting certain governance practices. Each of the rules relieves funds or their affiliates from certain prohibitions of the Act, and each involves some degree of oversight or approval by fund independent directors of otherwise prohibited transactions. We believe that the great preponderance of funds, and certainly all fund families, currently rely on one or more of these rules. The new exemptive conditions therefore are likely to affect virtually the entire industry, and most funds will regard the availability of one or more of the exemptions to be so important that they will have no alternative but to comply with the new conditions. By this indirect method, the Commission's proposals in effect would mandate new governance standards that depart significantly from provisions expressly incorporated by Congress in the statute.
Our comments on the new conditions proposed by the Commission follow.
A. Board Composition
In its Release, the Commission states that "a fund board that has at least a majority of independent directors is better equipped to perform its responsibilities," because it can act without the fund sponsor's concurrence and can "exert a strong and independent influence over fund management." In the context of the ten exemptive rules, the proposed additional requirement of a majority of independent directors would recognize the role assumed by the board in resolving conflicts of interest with fund affiliates, in circumstances where board action supplants Commission review or the express prohibitions of the statute.
If the Commission adopts this additional new condition, therefore, we suggest that consideration also be given to granting fund boards even greater latitude than current rules afford to approve affiliated and joint transactions under Sections 17(a) and 17 (d) of the Act. In 1990, when commenting on Proposed Reform of the Regulation of Investment Companies, Release No. IC-17534 (June 15, 1990), we noted that developments in state corporate and fiduciary law and in Commission regulations justified greater reliance on the informed actions of fund independent directors to assure, for example, that a proposed transaction with a fund affiliate meets the standards set forth in Section 17(b) or that a proposed joint transaction with a fund affiliate would not be less advantageous to the fund than to other participants. In our comments, we observed that regulations could specify criteria for the exercise of expanded authority, including, for example, consultation with counsel and financial advisers, the maintenance of records of board evaluations of approved transactions, the economic significance of the transaction, and the nature and proximity of the fund's relationship with the affiliate.
Developments since 1990, including those reflected in the Report of the Advisory Group on Best Practices for Fund Directors (June 1999), established by the Investment Company Institute, provide further substantiation that fund boards may be relied on for these purposes. If the Commission adopts the proposed new governance practices, therefore, we again recommend that it consider the appropriateness of a broader delegation to fund independent directors, to supplement those limited exemptions that have been developed over the years and that are, in effect, applications of the same concept.
The Commission also requests comment on whether, as an alternative, the exemptive rules should be conditioned on fund boards being composed of a super-majority or even exclusively of independent directors. Assuming the Commission has the authority to regulate in this manner, we believe it is best not to adopt such potentially far-reaching changes through administrative rulemaking, as opposed to action by the Congress on a full legislative record. By contrast, changes that would formalize practices already very widely and successfully implemented within the industry (e.g., the requirement that fund boards have a majority of independent directors or that nomination and selection of independent directors be entrusted to the incumbent independent directors as currently required for funds with distribution plans under Rule 12b-1) are more appropriate for independent rulemaking.
In addition, as a practical matter, we suggest that the Commission provide fund boards greater flexibility to address situations where board composition falls below applicable requirements in the event of the death, disqualification or resignation of an independent director. The selection, nomination and election of qualified candidates often can be a time-consuming process. The Release proposes a 60-day window where board action is sufficient to fill any vacancy, and a 150-day window if a shareholder vote is necessary. We believe these periods are not adequate, and would suggest instead a period of 90 days for board action and 180 days for shareholder action where required.
B. Selection and Nomination of Independent Directors
In its Release, the Commission states that "[o]ne recognized method of enhancing the independence of directors is to commit the selection and nomination of new independent directors to the incumbent independent directors." The Commission therefore proposes to import into other key exemptive rules a requirement to that effect, similar to the requirement currently set forth in Rule 12b-1(c) applicable to funds that have adopted distribution plans. The proposing Release indicates, and any adopting Release should reiterate, that the requirement is no different than that in Rule 12b-1.
The adopting Release also should make clear, as is the case with funds having distribution plans under Rule 12b-1, that board members who are not independent directors are not precluded from suggesting possible candidates for their colleagues' consideration. Moreover, the entire board should retain and exercise its formal authority under state law to elect or recommend to shareholders the election of new independent directors. This would not detract from the authority of the independent directors. Were the Commission to adopt the board majority requirement, independent directors would control the selection and nominating process. In the event of any disagreement, they could act as a majority to install their chosen candidates. No matter how they are brought to the attention of the independent directors, all independent director candidates would be required to meet the same exacting eligibility standards prescribed in the Act and Commission releases. Nonetheless, the approach we suggest would recognize that every individual serving on a fund's board has a fiduciary role under applicable law. The Commission should not, we believe, promote governance arrangements under which management directors are compelled altogether to abdicate or relinquish their responsibility. Even in a minority, management directors can and do make salutary contributions. In the final analysis, the election of new independent directors is best conducted through a process that builds consensus, a quality that is essential to the effective governance of the fund.
C. Independent Legal Counsel
The Commission states that the availability of independent legal counsel is "[a]nother recognized method of enhancing the independence and effectiveness" of fund boards. We agree. Indeed, we believe that one reason mutual funds have enjoyed the confidence of the investing public and have been so free of the scandals that have plagued other U.S. financial intermediaries is precisely because, by and large, they have been very well served by their lawyers.
The Commission now proposes, however, to limit -- to an unprecedented degree -- the exercise of judgment by independent directors in their choice of legal counsel. Independent directors would be prohibited from engaging any counsel that is not "independent," as defined by a new rule that departs dramatically from modern canons of legal ethics and from well-established corporate practice. Under this definition, a law firm would be disqualified from serving as counsel to a fund's independent directors if any of its professional staff at any time within the last two completed fiscal years of the fund had performed legal services of any kind for the fund's adviser or principal underwriter, for any person who provides significant administrative or business affairs management to the fund, or for any person who directly or indirectly controls, is controlled by, or is under common control with any such persons. The Commission proposes only de minimis relief from this disqualification standard: in the case of representation that is altogether minor or remote ("for example, a law-firm partner who represented an affiliate of the fund's adviser in a minor real estate transaction"), independent directors would be permitted to determine that "counsel's representation was `so limited that it would not adversely affect the counsel's ability to provide impartial, objective, and unbiased legal counsel to the [independent] directors'."
The proposing Release offers no explanation for why the exercise of discretion by independent directors concerning the engagement of counsel should be drastically limited in this way. By their very nature, the responsibilities accorded to independent directors require them to make judgments about numerous matters involving potential conflicts of interest. Many of these matters -- such as approval of advisory contracts or distribution plans or affiliated transactions -- can be complex, require highly refined business judgments, and have significant economic implications for fund shareholders. We believe that independent directors -- without the Commission's direction -- likewise can be entrusted to exercise appropriate judgment in connection with their utilization of legal counsel, a matter that is relatively straight-forward and familiar to most boards and business people.
Independent directors must be aware of any circumstances that pose potential conflicts of interest for counsel, if they are to make a fully informed judgment about whether a conflict is disqualifying or can be waived. Current standards of legal ethics require lawyers to make this disclosure, and it is commonly provided to fund boards and independent directors. Accordingly, we do not believe that rulemaking in this area is necessary. If the Commission concludes otherwise, however, we urge it to adopt not substantive disqualification standards (as it has proposed), but instead minimum procedural requirements necessary to assure that independent directors periodically learn of potential conflicts (including any mitigating steps taken or proposed by their counsel), consider them appropriately in connection with the engagement of counsel, and document their consideration in minutes of the board.1
II. New Disclosure Requirements About Fund Directors
The proposing Release asserts that new disclosure requirements are necessary to close certain "gaps" in the information currently available to investors about fund directors. The Commission notes that these gaps have arisen in part because state laws under which funds are organized generally no longer require annual meetings, and therefore shareholders do not receive proxy materials with information about fund boards as regularly as in the past. The Release also asserts that current disclosure requirements are deficient with respect to, among other things, information available to shareholders about the identity and background of fund directors and information about potential conflicts of interest affecting members of a director's "immediate family." Our comments on these aspects of the proposed new disclosures are as follows.
A. Background Information on Fund Directors
The Release proposes to utilize fund annual reports (as well as Statements of Additional Information (SAI) and proxy statements for the election of directors) to convey a range of identifying and background information about fund directors. We agree that information of this kind, if it is to be provided to fund shareholders, is better suited to the reports that funds are required to make annually to their shareholders, as opposed to fund prospectuses. We therefore support the proposals in this respect. We recommend that these changes be adopted in conjunction with other reforms to the contents of shareholder reports, in order to make the reports more informative and enhance their overall value to shareholders.
B. Potential Conflicts of Interest
The Commission proposes to expand dramatically the disclosure obligations of a fund director, to encompass information relating not only to the director but also to any and all members of the director's "immediate family." The Release suggests that this expanded disclosure is necessary because "there are ... situations" affecting family members that "could involve conflicts of interest." Accordingly, the rules, if adopted as proposed, would require detailed disclosures concerning a range of direct or indirect financial connections that may have existed over a period up to five years between a member of a fund director's "immediate family" and various entities or individuals related to the fund. Under the proposal, the disclosures would be mandatory even if the connections are unknown to the independent director and therefore could not possibly exert any influence. As the disclosures would be incorporated in the fund's SAI, incomplete or inaccurate information would carry possible prospectus liability.
The Commission's proposal raises numerous concerns.
First, the proposed disclosure requirements in certain respects (most importantly, in the range of possible financial connections and in the multitude of corporate entities and individuals covered) go well beyond the financial disclosures expected of any other director or officer in the private sector.2
Second, in light of the very extensive nature of the disclosable information, the proposal is unworkable. Fund directors have no means available to them to ensure the cooperation of the "immediate family" affected by the disclosures. Because the proposed disclosure requirements are complex in themselves, and highly intrusive in nature, it is foreseeable that the proposed exercise would prove difficult even in close families. Moreover, the proposal will place unwarranted administrative burdens on fund directors and fund management charged with the responsibility of gathering and evaluating this information. In many cases, a director's "immediate family" may comprise a dozen or even a score or more individuals. Substantial effort would be required not only to collect the required information initially but also to keep it updated on a regular basis.
Third, it is important to note that much of the information disclosed will not have any actual bearing on the independent director's qualifications as such under the Act nor on the integrity with which the director performs board responsibilities. At most the information will relate to a possible "appearance" of a conflict of interest. When publicly disclosed, however, the significance of the information easily may be misunderstood or mischaracterized. Similarly, any inadvertent omission of required information may be seen as an effort to evade disclosure. We are concerned that the proposed disclosure obligations will seem to many otherwise highly qualified individuals to be but a trap for the unwary, and cause them to decline to serve as an independent director.
Finally, we seriously question the value of this information to investors. It may be appropriate to require fund directors, in a fund's SAI or elsewhere, to disclose to shareholders circumstances involving themselves, a spouse or a dependent that could give rise to a conflict of interest. By contrast, information concerning the financial connections of a director's brother's wife, for example, will not materially assist shareholders in judging the director's loyalty to their interests. If the Commission truly believes that the loyalties of fund independent directors can be compromised so readily, then its proposal is under-inclusive -- and also should be extended to include not just immediate family but also domestic partners, friends, business associates, neighbors, club members, professional advisers, etc. Of course, there is absolutely no evidence to justify this view -- and we believe that the sixty-year record of the industry overall argues precisely the opposite. In the final analysis, as the Commission observes in its Release, "[f]und shareholders ... must depend on the character, ability, and diligence of persons who serve as fund directors to protect their interests."
Likewise, it is an appropriate practice to use annual questionnaires to fund directors to inquire whether they are aware of circumstances that may pose conflicts of interest involving a broader group of family members. The information collected in this manner helps in "vetting" nominee or incumbent independent directors -- that is, in ensuring that their statutory independence is unimpaired and that they have no disqualifying material professional or business relationships. It is neither necessary nor appropriate, however, to require that the results of this process be disclosed to shareholders. Insofar as the Commission itself desires access to the information for purposes of making any determinations under Section 2(a)(19)(A)(vi) of the Act, the proposed rules would address this need. We support the proposal that funds be required to retain questionnaires and other records created in this process.
We appreciate the opportunity to comment on the Commission's proposed rules. If we can be of any further assistance in this regard, please do not hesitate to contact any member of the firm's Investment Management Practice Group.
cc: Honorable Arthur Levitt, Chairman
Honorable Norman S. Johnson
Honorable Isaac C. Hunt, Jr.
Honorable Paul R. Carey
Honorable Laura S. Unger
1 . Some members of the bar have expressed concern that the proposal -- affecting "[a]ny person who acts as legal counsel" for independent directors -- might even be construed to deprive independent directors of legal advice provided in the normal course by fund counsel or counsel to the fund sponsor on matters committed to the board at large. We believe this result is not intended by the Commission and would be altogether counter-productive. If the Commission adopts a rule in this area, it may be useful to address this concern.
2 . The Release cites existing disclosure requirements as precedent justifying expansive new disclosure obligations for fund directors. In fact, these current disclosure standards are far more limited in certain respects. For example, the Release relies on the fact that the proposed definition of "immediate family" is similar to that used in the proxy rules. In the proxy rules, however, that definition applies only to very limited categories of transactions. See Item 404(a) of Regulation S-K. In addition, the definition of immediate family currently does not apply to beneficial ownership disclosures, as it would under the proposal; the existing proxy rules require only disclosure of securities beneficial ownership by directors and officers themselves, not by immediate family members. See Item 403 of Regulation S-K. Moreover, the Release states that the proposed definition would be "slightly broader" than the existing definition in Section 2(a)(19) of the Act, and thus implies at best a marginal expansion. Yet the inclusion of parent and sibling in-laws in the definition of "immediate family" significantly broadens the universe of individuals covered, to include more distant (and mayhap less cooperative) relations. Moreover, Section 2(a)(19) employs the term for a limited purpose -- not for the much broader purposes proposed in the Release. In short, the proposal does indeed borrow definitions and parts of definitions from existing sources. Nonetheless, the proposal deploys these borrowed elements to fasten new disclosure obligations on fund directors that far exceed those of any existing disclosure regime.