January 28, 2000
Mr. Jonathan G. Katz
Securities and Exchange Commission
450 Fifth Street, NW
Washington, D.C. 20549
Re: SEC Release No. IC-24082
File No. S7-23-99
Dear Mr. Katz:
The Commission's consideration of independence standards for outside mutual fund directors presents an opportunity to develop appropriate rules and understandings about ownership of variable insurance products by mutual fund directors in the context of those standards. This comment letter is limited to that subject.
Northwestern is the fifth largest life insurance company in the United States, based on assets. It has more individual life insurance in force than any other issuer, based on available information as of December 31, 1998. We offer variable annuities and variable life insurance. We sponsor two mutual funds, one which serves as the investment funding vehicle for our variable insurance products and one for sales directly to the investing public. Six individuals serve as the directors of both mutual funds. Two of the directors are interested persons of the funds, and four of them are not.
As the Commission recites in the captioned release, in the discussion of ownership of index fund shares: "Section 2(a)(19) [of the Investment Company Act of 1940] disqualifies an individual from being considered an independent director if he knowingly has any direct or indirect beneficial interest in a security issued by the fund's investment adviser or principal underwriter, or by a controlling person of the adviser or the underwriter." A footnote explains that this result flows from section 2(a)(19)(B)(iii) of the Act, in combination with the other clauses of section 2(a)(19). For planning purposes, we must assume that Northwestern is the issuer of our variable insurance products, notwithstanding the use of a separate investment account, and that both the investment adviser and the underwriter of our funds are controlled by Northwestern. Therefore an individual who owns a Northwestern variable annuity contract or variable life insurance policy cannot be an outside director of our mutual funds. Every other life insurance company issuing variable contracts faces the same problem, if the company operates its own mutual funds, but the issue is more acute for us because we are a large company, we specialize in the individual market and there are fewer likely mutual fund board candidates in Milwaukee than there are in New York.
The problem, of course, is that variable contracts are securities. Most of the business on our books at this date is life insurance, not annuities, and most of the life insurance is fixed, not variable. But the proportions are changing fast. Over the 32 years since we issued our first variable annuities, a number of our outside fund directors have owned fixed dollar life insurance policies issued by Northwestern. This is the case with some of our current outside fund directors. None of them owns variable contracts since, by definition, they would not be outside directors if they did. With just two exceptions our mutual fund directors have all been from the Milwaukee area. The other two were from Chicago. Business and professional people from this area tend to have some personal insurance with Northwestern. In the future, it is likely that it will be variable life insurance, and it is likely that the restraints of section 2(a)(19) will become a practical problem.
Variable annuities and variable life insurance policies are securities because the owners of these products bear the investment risk that they present. Fixed dollar annuities and life insurance policies are not securities because the insurance company bears the investment risk. On this analysis it is plain that the owner of fixed dollar products has more interest in the issuing company that bears the investment risk, and the owner of variable products has relatively less interest in the insurance company which simply manages a portfolio on his behalf. In both cases the insurance company bears the risks associated with mortality and expenses, and has a substantial relationship with the product it sells and administers, but it is incontrovertible that the fixed dollar product represents a larger interest in the insurance company than the variable product does, if all of the other factors are constant. Yet the law places no limit at all on fixed dollar products, in the context of section 2(a)(19), whereas there is a total prohibition for variable contracts.
The disclosure rules proposed by the Commission appropriately recognize that ordinary retail transactions of a mutual fund director and his family members are of no interest in assessing independence and should not be required to be disclosed. This should mean that life insurance, like bank accounts, may be excluded in fund disclosure documents. But where variable life insurance is involved, the disclosure issue is not reached, for independent directors, since they simply are not independent if they own variable contracts issued by the insurance company that operates the mutual fund with which they are involved.
The purpose of the independence standards is to prevent special relationships between fund directors and fund management where those relationships may impair independence at the expense of fund shareholders. The exception for ordinary retail transactions in the proposed disclosure rules recognizes that independence is not threatened where the independent director is treated just as any other ordinary retail customer. In the case of insurance products, the relationships with customers are formed in a regulatory environment that provides effective safeguards against unfair discrimination. Our dealings with our policyholders are not simply ordinary retail transactions. They must be handled fairly and equitably in order to satisfy the express demands of the insurance laws of Wisconsin and all of the other jurisdictions. Variable insurance products, except in the pension market, are also sold and administered in an environment that the Commission itself oversees, since these products are subject to the requirements of the Investment Company Act. There is no reason at all to suppose that the independence of mutual funds directors would be compromised by their ownership of these products.
The Commission's proposed disclosure rules would require frequent and prominent disclosure of ownership of mutual fund shares by the independent directors of the issuing funds, based on the belief that fund shareholders may expect the directors to invest in their own funds. This makes good sense, but the law forbids it where variable insurance products serve as the vehicle for fund directors to invest in their own funds. Independent directors should be encouraged to invest in the mutual funds they oversee, as the Commission has suggested, and this is just as true in the case of funds used as investment vehicles for our variable contracts. But the present rules proscribe even the smallest investment by independent directors in this situation.
The problem addressed here is not of the Commission's making. It is created by the language of the statute and the draftsman's assumption that ownership of securities indicates an equity stake in a mutual fund sponsor organization, presenting potential for compromise of the individual's independence. Variable annuities existed in 1970 when section 2(a)(19) was written, but they were new and not very common. It is likely that nobody thought about them in this context. Variable life insurance existed only in the minds of a few actuaries. The issue is becoming much more significant as variable products become a far bigger part of the life insurance scene. The Commission's proposal to require independence for a majority, or even more, of a mutual fund's directors makes the issue more pressing.
We would expect the Commission or its staff to provide relief by exemption or a no-action position if a fund found itself in a position where this was required, but the first case could well arise in a setting where there would not be time for adequate consideration of the issues. In the meanwhile, we and other companies may be compelled to pass over director candidates who are well qualified, or they may have to surrender their variable contracts in order to serve on our fund boards. It would be far better if the Commission would adopt an exemptive rule, like the one proposed for index funds, as part of the present project.
We appreciate your consideration of these views.
Very truly yours,
MERRILL C. LUNDBERG
Merrill C. Lundberg
Assistant General Counsel