COUNSELLORS AT LAW
January 28, 2000
Johathan G. Katz
Securities and Exchange Commission
450 5th Street, N.W.
Washington, D.C. 20549-0609
Subject:File No. S7-23-99; Release No. IC-24082 (the "Release") – Role of Independent Directors of Investment Companies
Dear Mr. Katz:
Baker & Hostetler LLP is a national law firm with more than 500 lawyers. We have offices in Cincinnati, Cleveland, Columbus, Denver, Houston, Long Beach, Los Angeles, Orlando, and Washington D.C. As a national law firm, we advise clients on a wide range of matters, from admiralty to trusts and estates. We also serve as legal counsel to investment companies, investment advisers, principal underwriters and administrators of investment companies, and to their control persons.
We agree in principle with the policy goals of enhancing the independence and effectiveness of the boards of directors of investment companies and of providing investors with more information about the directors themselves, as set forth in the Release. We also agree that one way to achieve these goals is to encourage a fund's independent directors to retain their own qualified counsel. We believe, however, that the independent directors should be free to select counsel of their choice based on standards of independence and other criteria the independent directors, in their sole judgment, determine to be most relevant. We are concerned that the proposed attempts to manage this process administratively by defining "independent legal counsel" will have the unintended effect of reducing significantly the number of competent lawyers and law firms which qualify as "independent legal counsel," will introduce an enormous level of complication, uncertainty and time spent in the process of determining independence, and ultimately may discourage independent directors from hiring their own counsel.
Two aspects of the proposals outlined by the U.S. Securities and Exchange Commission ("SEC") in the Release are most troubling—the definition of "independent legal counsel" in proposed Rule 0-1(a)(6)(i) and the severe penalties to a fund, its shareholders and its directors in the event of a subsequent determination that independent legal counsel to a fund's outside directors was in fact not "independent."
Rule 0-1(a)(6), if adopted, would define "independent legal counsel" as follows:
(i) A person is an independent legal counsel with respect to the directors who are not interested persons of an investment company ("disinterested directors") if:
(A) The investment company reasonably believes that the person has not acted as legal counsel for the company’s investment adviser, principal underwriter, administrator (collectively, "management organizations"), or any of their control persons at any time since the beginning of the company’s last two completed fiscal years; or
(B) A majority of the disinterested directors determine (and record the basis for that determination in the minutes of their meeting) that the person’s representation of any of the company’s management organizations or any of their control persons is or was so limited that it would not adversely affect the person’s ability to provide impartial, objective, and unbiased legal counsel to the disinterested directors.
(ii) For purposes of paragraph (a)(6)(i) of this section:
(A) The term person has the same meaning as in section 2(a)(28) of the Act (15 U.S.C. 80a-2(a)(28)) and, in addition, includes a partner, co-member, or employee of any person; and
(B) The term control person means any person (other than an investment company) directly or indirectly controlling, controlled by, or under common control with any of the investment company’s management organizations.
The proposal contains two alternative definitions of "independent legal counsel." The first alternative (in Rule 0-1(a)(6)(i)(A)) is objective in nature, meaning that the question of whether a law firm fits under this definition can be answered with certitude—in theory at least—by comparing ascertainable, historical facts against the language of the definition itself (the "objective standard"). The second alternative (in Rule 0-1(a)(6)(i)(B)) is subjective in nature, meaning that it requires independent directors to exercise judgment—and to do so based upon a standard that, because of its imprecision, is capable of producing disagreement among reasonable people (the "subjective standard"). The use of these alternative definitions, read in conjunction with the proposed definition of "control person," raises the following problems:
The independent directors may face difficulties finding counsel they are willing to hire that qualifies as "independent" under the proposed Rule.
Many lawyers with extensive experience and competence in representing mutual funds work in large law firms. However, a large firm with multiple offices and thousands of active clients may find it impossible to meet the objective standard, especially in larger and more sophisticated investment company complexes. An investment company complex which is advised, administered and distributed by a discrete group of companies (for example, Fidelity and Vanguard) will not be as problematic as those complexes whose investment advisers, administrators or distributors are part of large, multi-faceted financial services firms such as Salomon Smith Barney (part of the Citicorp group) or a large insurance company. It is unlikely, for example, that there are many large law firms that have not done work from time to time for one or more of the companies within a large financial services conglomerate such as the Citicorp/Travellers Group.
If an investment company complex utilizes sub-advisers, especially in a multi-manager arrangement, or subadministrators, the problem of proving that no legal work in the past two years has been done or will be done going forward becomes exponentially more complex depending upon the number of subadvisers or subadministrators and the structure and breadth of their corporate enterprises. We believe that some complexes that utilize multiple managers will have well in excess of 500 entities that could cause legal counsel not to be deemed independent under the objective standard.
If a law firm is unable to meet the objective standard, we realize that the proposed Rule views the subjective standard as an acceptable alternative. However, the subjective standard is imprecise, could result in a large divergence of interpretation and application from one fund group to another and presents its own set of problems.
The independent directors of a fund, when faced with the issue of its counsel’s independence, may find it more difficult to rely on the subjective standard because:
The results of being wrong or being second guessed by the SEC or a plaintiff's lawyer are so punitive in nature as to prompt independent directors to forego independent representation rather than be wrong. It has been our experience that fund directors are generally cautious in regard to the decisions they make even when the consequences of a decision would be relatively minor. Because the proposal conditions a fund’s ability to rely upon ten vitally important rules on the independence of counsel to the fund’s independent directors, we believe that the independent directors will be (and should be) extraordinarily cautious in making the decision to hire counsel in the first place.
The independent directors may not feel comfortable placing at risk the fund’s ability to rely upon ten vitally important rules based on their own judgment about whether the law firm meets the subjective definition of "independent legal counsel"—knowing that their judgment, in all but the most obvious of cases, will be open to be debate. (The definition itself contemplates that reasonable people may disagree on this issue, since only a majority of the independent directors is required to make this determination.)
In an era of consolidating financial services, the problem of continuously monitoring the independence of the independent directors' counsel may become too burdensome and uncertain. For example:
In the manager-of-managers context, the investment adviser, before making a recommendation to hire a new subadviser, would need to investigate whether the subadviser or an entity in its corporate structure uses, or within the past two years ever used, the independent directors' counsel. If the investment adviser determines that such representation exists or existed, it is then faced with the choice of (a) not proposing such subadviser or (b) prior to bringing it to the Board for approval, having the independent directors determine whether they need to fire their counsel and find new counsel, even before they have had the opportunity to evaluate the proposal to hire the new subadviser. The emphasis then no longer is on determining who is the best subadviser for the fund in question but rather on the trade off between disrupting the investment management of the funds and disrupting the operation of the fund complex itself by adding significant time and expense to the independent directors' obligations.
If a fund's service provider or another member of its corporate family purchases or merges with another entity, because of such entity's relationship with the fund's independent directors' counsel, such an event could cause such counsel to no longer be independent under the objective or subjective standard (a "disqualifying event"). At the time of the disqualifying event, is the fund no longer able to rely on the exemptive rules? What if the Board later meets and determines that the independent directors' counsel meets the subjective standard? Was the fund unable to rely on the exemptive rules during that interim period? What if the Board finds that counsel did not meet the subjective standard? Has the fund been unable to rely on the exemptive rules since the disqualifying event occurred or since the Board made its determination?
One of the most significant problems will be that of detecting remote disqualifying events within large financial services organizations and multi-manager fund complexes that would result in formerly independent counsel no longer qualifying as independent under the objective standard and possibly not qualifying under the subjective standard. Depending on the fund service provider to advise fund management, the independent directors or the independent directors’ counsel of all such potentially disqualifying events is unrealistic. Depending on independent counsel’s internal system to identify such a conflict would test the most comprehensive of such systems and may also be unrealistic.
Assuming all potential conflicts can be identified, which for the reasons stated above is far from certain, determining compliance with either the objective or subjective standard will present additional difficult issues for law firms and independent directors. For example, to what extent do the independent directors need to know the details of the firm’s client base and the matters on which the firm has advised its clients, including the amounts billed and services performed, what is the relevant time frame in regard to this information, and what if the firm is unable (for ethical or other reasons) or unwilling to disclose this information?
In addition we have the following concerns:
It is not clear in the Release, in the proposed amendments to certain exemptive rules, and sometimes in practice, as is assumed, when a lawyer or law firm is "legal counsel for the disinterested directors." Often, and, likely in a current majority of the cases, investment companies hire law firms or lawyers to represent the investment company as an entity, including all of its directors, but the independent directors do not separately hire additional counsel to represent them as a group. In this setting, counsel for the fund often meets with and advises the independent directors separately on matters such as the annual review of the investment advisory agreement and 12b-1 plan and on other issues. In such a setting, has the lawyer or law firm become "legal counsel for the disinterested directors" that is required to be "independent legal counsel" because of counsel’s advice to the independent directors? We think not, but we recommend if the proposed Rule is adopted that this point be clarified and confirmed. In other settings, often in larger fund complexes, when the fund has hired legal counsel for the entity, including all of the directors, and the independent directors also have hired separate counsel, it is clear that the additional counsel hired by and separately representing the independent directors is "legal counsel for the disinterested directors." The paragraph on page 11 of the Release discussing the ability of "independent legal counsel" to the fund’s independent directors also to provide service to the fund itself without the loss of independence introduces an element of uncertainty as to when a lawyer or law firm is not "legal counsel for the disinterested directors" and should be clarified.
As a matter of public policy we believe it is both unwise and inequitable, almost to the extent of being punitive, to permit funds whose independent directors have elected not to hire "independent legal counsel" to rely on exemptive rules utilized for competitive reasons by most investment companies while at the same time prohibiting investment companies whose independent directors have hired separate counsel they are comfortable with but which is not "independent legal counsel" within either Rule 0-1(a)(6)(i)(A) or (i)(B) from relying on such exemptive rules.
If the proposed Rule is adopted it should be clarified that counsel which has performed services for an entity which was, but no longer is, the investment company’s investment adviser, principal underwriter or administrator or their control persons since the beginning of the investment company’s last two completed fiscal years is not disqualified as "independent legal counsel" because of such representation.
Finally, in some cases, the need for separate counsel arises under difficult circumstances in which time is short and the issues are complex. The proposed rule, if adopted, would increase the difficulty of these situations by interjecting the additional question of whether separate legal counsel would be independent under a definition that is broad in one respect and imprecise in the other. This question itself may prove to be more difficult to resolve than the issues that gave rise to the proposed engagement of counsel in the first place.
For the reasons cited above we oppose the adoption of rules which attempt to define when "legal counsel for the disinterested directors" is "independent legal counsel" and recommend that the issue of counsel’s independence be left to the sole judgment of the independent directors.
BAKER & HOSTETLER LLP
Charles H. Hire, Esq.
Kristin H. Ives, Esq.
Brian T. Deas, Esq.