February 1, 2000
60 Heritage Drive
Pleasantville, NY 10570
Jonathan G. Katz, Secretary
Securities and Exchange Commission
450 Fifth Street
Washington, D. C. 20549-0609
Re: Release 34-42007, File No. S7-23-99
Role of Independent Directors of Investment Companies
Dear Mr. Katz:
I have been investing in closed-end funds for twenty-five years and I am currently an investment advisor to a limited number of clients. I am also a shareholder activist. Over the past few years, I have submitted a number of Rule 14a-8 shareholder proposals to closed-end funds and have conducted four proxy contests in which I sought to elect directors of a closed-end fund. As a result of one such contest, Gerry Hellerman and I were elected as directors of Clemente Strategic Value Fund (f/k/a Clemente Global Growth Fund) and we continue to serve in that position. As far as I know, we are the only independent fund directors in the country who were elected in a contested election and were not nominated by an affiliated person.
Yesterday, I learned that four closed-end funds had taken anti-shareholder initiatives, thereby perpetuating a disturbing and depressing trend in the industry. The Germany, New Germany and Central European Equity Funds announced that they "have elected to be subject to new subtitle 8 of Title 3 of the Maryland General Corporation law, vesting in the Board the exclusive power to fill director vacancies and fix the size of the Board and increasing the stockholder vote required to call special meetings and remove directors. The Funds have also adopted formal qualifications for directors, which require knowledge and experience in matters related to the Funds' investment focus." Also, The Emerging Markets Infrastructure Fund filed (on EDGAR) its amended by-laws which increased the requirement necessary to call a special meeting (from 25% to 50% of the outstanding shares) and purport to strip the shareholders of their right to amend the by-laws, a right they enjoyed under the fund's former by-laws.
These developments have inspired me to submit this letter in the hope that it may influence the Commission. Blatant entrenchment tactics like establishing "qualifications" so burdensome that Chairman Levitt would not meet them are difficult to reconcile with the notion of independent directors who are supposed to be watchdogs for the shareholders. Watchdogs are not supposed to attack their masters. If these sorts of things do not raise any concerns at the Commission, then my efforts will probably be futile. Hopefully, that is not the case.
In February 1999, the Commission hosted a two-day Roundtable on the Role of Independent Investment Company Directors. Outspoken critics of the status quo were noticeably absent from the panels. Eight months later, the Commission issued a 127- page release proposing a number of amendments to its rules designed to "enhance the independence and effectiveness of boards of directors of investment companies and to better enable investors to assess the independence of directors." While briefly noting that independent fund directors recently have been targeted for criticism, the release did not provide any examples of such criticism or attempt to assess the merits of the allegations. The fundamental premise from which the criticism stems is that, with few exceptions, the interests of the independent directors are more closely aligned with the investment advisor than with the shareholders.
The proposed amendments, on the other hand, are premised on a belief that, for the most part, independent directors are faithful "watchdogs," ready to pounce on any advisor brazen enough to try to get away with something that will be detrimental to shareholders. Thus, according to the "Background" section of the release:
We endorse the sentiments of the Roundtable participants who favor enhancing the effectiveness and independence of fund boards of directors. While those sentiments can be fully achieved only through amendments to the Investment Company Act, we are impressed by the consensus of the participants concerning the importance of the role of independent directors and the conditions they believe are necessary to enhance the effectiveness of those directors. We therefore are proposing rule amendments designed to reaffirm the important role that independent directors play in protecting fund investors, strengthen their hand in dealing with fund management, reinforce their independence, and provide investors with better information to assess the independence of directors.
In the November 29, 1999 issue of Forbes, Thomas Easton and Michael Maiello wrote a 1-page story entitled "Nice Work if You Can Get It," about a number of ex-politicians that earn up to $253,000 per year as independent directors for mutual fund complexes. Easton and Maiello are not as sanguine as the Commission about the value of independent directors. They write: "Independent? Even when performance is lousy, fund managers are rarely fired; expenses only grudgingly go down; and, in the ultimate litmus test, we can't recall a time when, during the acquisition of the management contract for a fund, the fund's owners--the shareholders, that is--got a nickel in compensation. Who's side are the directors on?"
It is not surprising that Easton and Maiello take a dim view of the proposed amendments:
SEC Chairman Arthur Levitt has proposed a rule change that would compel funds to list their directors and their compensation in material routinely provided to shareholders. Of equal interest, directors may also be required to disclose their investments in the funds they supervise, something required for every corporate director.
Here's a counterproposal: Dump the whole charade. Accept the fact that fund companies run funds in their own interest. When they fail to look after their customers, the smart ones flee. Take note: This is really the only protection anyone has.
The contrast between the Easton-Maiello thesis and the Commission's view is pretty stark. If the former is accurate, then the release is the equivalent of a manual on how to better clean the Emperor's new clothes. Thus, until the charges leveled against independent directors are honestly evaluated, it is premature to recommend any fixes at all.
My own experience as an investor and a shareholder activist in closed-end funds confirms the Easton- Miello thesis in spades. I could write a book detailing the abuses that I have seen blessed by independent directors of closed-end funds. One such abuse is a rights offering that increases the advisor's annual fee while diluting per share NAV. Any independent director that would approve such an offering is either incompetent or corrupt. I estimate that there have been at least fifty such offerings in the past ten years. Draw your own conclusion.
In any event, I think I am safe in predicting that the sort of proposals contained in the release will have no discernible effect on shareholder protection and will do nothing to pacify the critics of investment company governance. For example, it seems pointless to compel additional disclosure that may suggest that a director is not all that independent when shareholders have no practical way to act on that information, i.e., by removing and replacing him or her.
The abuses that led to passage of the Investment Company Act involved mostly closed-end investment companies. The ICA barred the worst of those abuses. Even though this may be heresy, I don't think independent fund directors deserve any of the credit. I will go so far as to say that if all independent fund directors resigned tomorrow, nobody would miss them. Shareholders of open-end funds, in particular, derive no benefit from independent directors. Those shareholders are not really owners. They are customers and market discipline is the only real deterrent to the abuse of customers. Like any business that wants to be successful, an open-end mutual fund must meet the wants and needs of its customers, i.e., investors. Fund groups like Fidelity or Vanguard satisfy customers while those like Steadman or Bull and Bear do not. It has nothing to do with the performance of the independent directors of those complexes.
When one is considering opening a bank account or purchasing insurance, he or she compares price, service and reputation. The customer does not know or care who are the directors of the bank or insurance company. And, while no such directors should place the customer's welfare above that of the company's stockholders, that is not to say that they do not care about customer satisfaction. They most likely do but only because it is important to the company's success. Adam Smith called this phenomenon the "invisible hand." Today we call it market discipline. Open-end fund shareholders do not need or benefit from the artifice of "watchdogs" that supposedly subordinate the interests of the advisor who is really responsible for the directors' employment to the interests of customer-investors who don't even know who the directors are. For example, if the advisor incorrectly believes that it can generate more income by raising fees, investors will punish it -- just as consumers punish any business that charges excessive prices.
In sum, the proposed rules are worse than useless (with the exception discussed below). They will not benefit shareholders but will impose some costs on them. Therefore, none of them should be implemented.
Amazingly, one proposal is demonstrably harmful to shareholders and provides no conceivable benefit. That proposal is to deny shareholders the power to ratify or reject the selection of the independent auditor if an audit committee comprised of independent directors makes the selection. While it is true that, as the release notes, " shareholders rarely contest votes over the ratification of the selection of a fund's independent accountant," the same can be said about almost any matter that is put to a shareholder vote. Nevertheless, it is important to keep open the possibility. For example, a report released on January 6, 2000 by the Commission documented an extraordinary number of violations of the auditor independence rules by professionals of PricewaterhouseCoopers (PwC). The report stated that PwC conceded that the widespread non-compliance with the rules "reflected serious structural and cultural problems in the firm." Presumably, the proxy rules require any investment company seeking shareholder ratification of PwC to disclose this information. The knowledge that shareholders may then vote to reject PwC may cause the board to seek another auditor. This would send a message to all public accounting firms that there is a price to be paid for flouting the independence rules. If the proposed amendment were implemented, that message would be much less likely to be heard, thereby resulting in complacency among public accountants and hence, diminished investor protection.
In my opinion, the most critical passage of the proposing release is buried in footnote No. 10, which reads as follows:
See SEC, Report on the Public Policy Implications of Investment Company Growth, H.R. Rep. No. 2337, 89th Cong., 2d. Sess. 12, 127, 148 (1966) ["Public Policy Report"] (stating that funds generally are formed by their advisers and remain under their control, and that advisers' influence permeates fund activities); Wharton School of Finance and Commerce, A Study of Mutual Funds, H.R. Rep. No. 2274, 87th Cong., 2d Sess. 463 (1962) ["Wharton Report"] (discussing the dominant position of advisers in the control of funds and the infrequency with which funds have a separate existence from their advisers); see also Clarke Randall, Fiduciary Duties of Investment Company Directors and Management Companies Under the Investment Company Act of 1940, 31 Okla. L. Rev. 635, 636 (1978) ("The adviser's control and influence over the fund is very nearly total."); In the Matter of Steadman Security Corporation, Investment Company Act Release No. 9830 [1977 Transfer Binder] Fed. Sec. L. Rep. (CCH) ¶ 81,243, at n.81 (Jun. 29, 1977) ("[T]he investment adviser almost always controls the fund.").
The above excerpts suggest that the Commission's proposals do not really address the underlying problem, i.e., advisor domination of the fund. Furthermore, there is abundant evidence that the assumption that independent directors generally are (or want to be) an effective deterrent to the investment advisor's control is false. Investors are harmed when directors who are really controlled by the advisor are given a misleading imprimatur of "independence." Ironically, that is what the ICA does. Consequently, the proposed rules are at best, useless and at worst, counterproductive because they perpetuate a myth of independence.
To conclude, I urge the Commission to stop averting its eyes from the widespread criticism that the loyalties of independent directors lie more with the advisor than with the shareholders. The Commission's credibility is diminished to the extent that it persists in ignoring the evidence. I do not expect to win any popularity contests by presenting the truth as I see it. As President Reagan used to say, "Facts are stubborn things." And I understand that one fact of political life is that it is not easy to take on a powerful industry. So, if that is not feasible, I recommend that the Commission abandon its proposals entirely. If, however, the Commission is determined to clean the Emperor's clothes, I am at least grateful that we have the right to speak truth to power and that we still have a free press that can tell the people that the Emperor is naked.
Very truly yours,