January 28, 2000
Re:Comments on Proposed Role of Independent Directors
File No. S7-23-99
Jonathan G. Katz, Secretary
Securities and Exchange Commission
450 Fifth Street, N.W.
Washington, D.C. 20549-0609
Dear Mr. Katz:
As outside counsel for open-end and closed-end management companies, we appreciate the opportunity to comment on the Commission's proposed amendments to rules under the Investment Company Act (Rel. IC-24082, herein the "Release") to enhance the effectiveness of independent directors of management investment companies. We generally support the Commission's proposals, but we believe two aspects of the proposed amendments should be reconsidered.
Independent Counsel. One of the proposals would amend ten exemptive rules to require that funds relying on any of these rules must have independent directors who constitute at least a majority of the fund's board of directors and that any counsel to the independent directors must be independent. We have significant reservations regarding the proposal that any legal counsel for independent directors of a management company relying on any of the specified rules must be independent.
We request that the Commission consider further the practical difficulties and expense that we believe are likely to result from this proposal. First, it is unclear whether the proposed amendments would require independent directors to engage independent legal counsel on all matters they consider, or merely when carrying out their responsibilities under one or more of these ten rules. By using the words "any legal counsel", the Release at least implies that reliance on just one of the rules would trigger a requirement that independent directors berepresented by independent counsel on all legal matters requiring their attention. It appears that if counsel advises a board generally - for example, on director duties under state law or requirements of valuation - that the rule would require the use of independent counsel if any counsel (either an outside firm or an officer or employee of the adviser) advises the board as a whole regarding legal requirements under the 1940 Act, and applicable rules and interpretations thereunder. We submit that with a board comprised of a majority of independent directors, those directors should have the flexibility to choose the issues on which they believe engagement of independent counsel is warranted.
Second, we submit that not every issue involving a potential conflict of interest which specifies a determination by independent directors rises to the level of requiring independent counsel. We agree that consideration of Rule 12b-1 or 17e-1 matters, which can involve substantial sums of money, may indeed warrant representation by independent counsel. However, given the small amounts of money and clarity of issues involved in the following rules, we do not believe the minor conflicts involved with allocating premiums on joint fidelity bonds (Rule 17g-1) or liability insurance (Rule 17d-1) should require independent counsel. Similarly, assuming an interim advisory contract (Rule 15a-4) is on the same terms as the previous agreement and is required because of a technical assignment of an adviser by sale of a remote parent, we believe it is the proposed permanent agreement (to be approved by shareholders) - not the interim agreement - that deserves scrutiny by independent counsel. Similarly, Rule 10f-3, which prohibits benefits to affiliated underwriters, does not involve difficult conflict issues. While we agree, based on the complexities of the following rules, that a board needs advice of counsel regarding determinations under Rules 17a-71, 17a-8, 18f-3 and 23c3-3, we question whether there is any conflict with the adviser or other service providers that should precipitate a requirement for independent counsel.
Third, based on a variety of considerations, we believe that aside from reviewing arrangements under Rules 12b-1 (distribution expenses) or 17e-1 (compensation to affiliated brokers in exchange transactions), independent directors should retain the flexibility to determine whether assistance by independent counsel is warranted or appropriate. We think this is especially true for funds or complexes with aggregate assets of less than $200 million. Under "Cost Benefit Analysis", the Release notes that "The Commission . . . has no reasonable basis for determining whether this substitution of counsel is likely to cause the independent directors' costs of legal counsel to increase." We submitthat the cost is likely to be substantial, especially if independent counsel is needed not only for consideration of responsibilities under the specified rules but for any matter in which the board is advised by outside counsel. We urge that independent directors should be apprised of the ICI recommendations on best practices, which admit that these recommendations "may be impracticable or unnecessary for all funds to adopt". Ultimately, however, the independent directors should be vested with the flexibility to determine, based on the extent of the conflict and the costs involved, whether use of independent counsel is warranted to protect the interests of fund shareholders.
Finally, we submit that major law firms, including our own, represent thousands of clients and that, with the consolidation of the financial services industry, most firms would be disqualified from being considered independent. While we support the authorization for a fund's independent directors to determine whether some minor conflicts raise significant issues regarding independence, we submit that the definition should be narrowed with respect to control persons of the adviser to matters that involve both significant services (1% of fees) and a connection to the activities of the adviser. Otherwise, fund boards will be required to spend significant amounts of time assessing the remoteness of conflicts for their outside counsel - which will take away from their ability to concentrate on adviser conflicts and could itself involve the need for yet another independent counsel. This could also restrict their representation to small specialty firms that are willing to forego representing financial conglomerates in any capacity.
Disclosure Regarding Conflicts of Interest. The Release also proposes to require disclosure concerning any direct and indirect material interest, by either fund directors or their immediate family members (as expanded in the proposal), in any material transaction during the latest two years or that is proposed. The proposals would require disclosure of transactions with parties as remote as a policy-making officer of a company under common control with the fund's adviser, principal underwriter or administrator or of any investment company with an adviser, principal underwriter or administrator under common control with the fund, or even a company that has a relationship with a related party of a fund. We also note that the definition of interested person was recently expanded in the Gramm-Leach-Bliley Act, which will make it even more difficult to find disinterested directors. We submit that these proposals raise significant questions as to whether all the types of conflicts and related persons can be identified in a way that can be understood and reported by directors, let alone all the members of their immediate families. At a minimum, a standard of "knowingly" (similar to Section 17) should exclude relationships when a respondent reasonably has no awareness of a conflict.
Please do not hesitate to call the undersigned at 212-450-4684, Pierre de Saint Phalle at 212-450-4525 or Gary Granik at 212-450-4721 if the Staff would like to discuss these recommendations or would like further information on any of these points.
1 The absence of a significant conflict between funds having the same adviser is evidenced by the Release's advice that "the proposal would not preclude counsel from representing independent directors of multiple funds affiliated with the same management organization."