December 3, 2002
Mr. Jonathan G. Katz
Re: Request for Comments on Proposed Rules Concerning Disclosure Required by Sections 404, 406, and 407 of the Sarbanes-Oxley Act of 2002- File No. S7-40-02.
Dear Mr. Katz:
The Financial Services Practice Group of Dechert is pleased to have this opportunity to comment on the Securities and Exchange Commission's proposed rules concerning the disclosure required by Sections 404, 406, and 407 of the Sarbanes-Oxley Act of 2002 (the "Act"). The proposed rules were presented in the Commission's request for comment set forth in Release No. IC-25775, dated October 22, 2002.
Dechert is an international law firm with a wide-ranging investment management practice that serves clients in the United States and worldwide. Our clients include many U.S.-registered open-end and closed-end management investment companies (collectively, "Funds"), managers of Funds, and unit investment trusts ("UITs").
I.Proposed Financial Expert Disclosure Requirement
The Commission has proposed to require both issuers other than registered investment companies ("Operating Companies") and Funds to disclose the number and names of any persons that the issuer's board of directors has determined to be the financial experts serving on its audit committee; whether the financial expert or experts are "independent," and if not, an explanation of why they are not. If the board has not named a financial expert to serve on the audit committee, the Operating Company or Fund must disclose this fact and explain why the audit committee does not include a financial expert.
As discussed below, we strongly believe that Funds should be excluded from the disclosure requirement. Specifically, the nature of Fund accounting is such that Funds rarely, if ever, are susceptible to the potential abuses that the disclosure requirement is intended to address. The disclosure requirement as proposed is unlikely to achieve its intended goal of strengthening a Fund's audit committee and may discourage qualified persons from serving on a Fund's board or audit committee.
A. The Commission Should Exclude Funds from the Disclosure Requirement.
1. Funds Do Not Present the Same Accounting Issues as Do Operating Companies.
As noted by the Commission, recent accounting and corporate scandals highlighted the inability of many Operating Companies' boards of directors or audit committees to adequately oversee their management and auditors. These scandals also served as the impetus for the proposed financial expert disclosure requirement. We do not wish to downplay the recent turmoil that these scandals have brought to our financial markets. However, it is important to recognize that the integrity of a Fund's financials is based on different and far more straightforward accounting concepts than those of an Operating Company.
The Commission has recognized that generally accepted accounting principles and generally accepted auditing standards explicitly contemplate numerous circumstances in which Operating Companies, in applying accounting policies, will be required to exercise judgment and make estimates for purposes of preparing their financial statements.1 This use of estimates results in the presentation of many amounts that are, in fact, approximate rather than exact.2 These estimates necessarily reflect significant management judgment and uncertainty.3 By contrast, there are few circumstances in which Funds are required to exercise judgment and make estimates in applying accounting policies. Management judgment and uncertainty do not significantly affect the results presented in Fund financial statements.
The objective of a Fund's financial statements is to present net assets, results of operations, changes in net assets, and financial highlights resulting from investment activities and, if applicable, from capital share transactions.4 Consequently, Fund accounting is far less complicated than accounting for Operating Companies. For example, no less than 85% of an open-end Fund's net assets must be comprised of securities traded on an active market.5 As required by the Investment Company Act of 1940, as amended ("ICA"), these securities are valued at their last quoted sales price.6 Securities for which market quotations are not readily available must be valued at fair value as estimated in good faith by or under the supervision of a Fund's board of directors.7
Accordingly, the valuation of a Fund's underlying portfolio instruments is a more critical issue to Funds than complex Operating Company accounting issues such as the choice of initial accounting policies or estimates of the effects of future events. In fact, the few recent "accounting" cases involving Funds have revolved around valuation of the Fund's portfolio.8 Given these facts, we believe that it would be highly inappropriate for the Commission to impose on Funds a disclosure requirement relating to the designation (or not) of "financial experts" that has been designed to combat accounting problems that seldom arise. The need for such a rule simply does not exist in the case of the Fund industry.
2. The Commission's Proposed Requirement that Funds Identify their Financial Expert is Likely to Impose an Unreasonable Burden on the Financial Expert and the Other Directors.
The Commission has stated that the designation of a financial expert should not impose a higher degree of individual responsibility or obligation upon that financial expert. Despite this statement, however, an investor may believe that a higher duty of care exists. This may give rise to litigation if an investor believes that a financial expert has failed to satisfy this higher level of care. Disclosure of the identity of a financial expert is likely to place an unreasonable burden on that director, as plaintiff's counsel would most likely attempt to discredit the expert's qualifications in order to cast doubt on that director and on the board itself.
State law may also impose upon a "financial expert" a higher standard of care than that imposed on an ordinary director. For example, the Maryland General Corporation Law requires a director, in performing his or her duties, to act as an ordinarily prudent person in like circumstances.9 As such, a plaintiff's attorney may claim that the standard of care is that of an ordinarily prudent "financial expert," and that a Fund's financial expert did not act in good faith by reason of withholding or negligently exercising his or her special expertise.10 Furthermore, the financial expert disclosure requirement may threaten a board's ability to rely on an audit committee's recommendation11 because the board could be deemed to have acted unreasonably in accepting information from an audit committee which makes a recommendation in contradiction of a "financial expert's" views. An audit committee may also be viewed as having acted unreasonably if it agrees with the view of the non-financial expert, even though the financial expert does not have the same experience in trading that type of security.
In light of the above discussion, the threat of increased liability for both a financial expert individually and the board as a whole may serve as a disincentive for qualified persons to serve on a Fund's board or audit committee. Moreover, because of the increased threat of liability, the financial expert and the board may be less likely to freely engage in candid discussion. It is imperative that board members maintain the ability to engage in frank discussion, ask difficult questions, and challenge the views of their fellow board members. Directors must not be discouraged in any way from active and constructive debate with fellow board members, as this is the primary and most effective12 method by which a board gathers and analyzes the information necessary to reach a decision that is in the best interest of the Fund's shareholders.
We are aware that the Commission has proposed to permit Fund boards the option of not designating financial experts as long as the Fund discloses why it has not done so. However, the failure of a board to appoint a "financial expert" may expose it to claims from plaintiff's counsel that the board has violated its duty of care by failing to properly oversee a Fund's management and auditors, making this alternative less attractive for Fund boards.
Based on the foregoing discussion, we recommend that Funds be excluded from the financial expert disclosure requirement. Adopting the proposed rules in final form would not provide any additional protection to Funds and their shareholders and likely would encourage strike suits based on unfounded claims that a "financial expert" and/or a board has not fulfilled responsibilities imposed under state and federal law.13 However, if the Commission decides to adopt the proposal in final form, we have a number of comments on the terms of the proposal as set forth below.
B. The Commission Should Tailor the Definition of Financial Expert as Applied to Funds.
The proposed definition of financial expert is comprised mostly of accounting attributes as opposed to financial attributes. Although this may be appropriate in the context of an Operating Company, it is too narrow in the Fund context. Accordingly, we strongly urge the Commission to modify its proposed definition of financial expert as it applies to Funds.
The Commission stated that the primary benefit of having a financial expert serving on an audit committee is that the person can, by virtue of his or her enhanced level of financial sophistication or expertise, serve as a resource for the audit committee in carrying out its functions. Unlike an Operating Company, a Fund's financial expert need not have significant accounting experience to serve as a useful resource to the audit committee or board. In fact, frequently a Fund's financial expert would serve as a greater and more constructive resource for the audit committee and board if he or she brought to the table a broader financial expertise regarding the types of assets held in a Fund's portfolio (e.g., derivatives and other exotic instruments) and the trading and valuation of such investments.
As discussed above, a Fund's board of directors has a statutory obligation to supervise a Fund's valuation practices and procedures and attempt to prevent or remedy any erroneous valuation of the Fund's portfolio securities. There is no guarantee that an "accounting" financial expert, as proposed by the Commission, will possess the requisite knowledge and expertise needed to accurately assess a Fund's portfolio and its valuation. For example, a board may frequently be required to make or evaluate a fair value determination of a security for which a market price is not readily available.14 What would help a board called upon to make such a determination is a director who has familiarity with similar instruments, not simply accounting expertise.
Based on the foregoing, we recommend that the Commission, if it determines that the financial expert disclosure requirements should apply to Funds, modify the definition of "financial expert" to include factors relevant to the real accounting issues faced by a Fund's board, such as a person's experience with and/or ability to understand the characteristics and market behavior of the securities held by a Fund's portfolio. Access to financial expertise of this nature would greatly assist a board in its role as the protector of the Fund and its shareholders.
As noted in the proposing release, the Act does not specifically require that a company disclose whether its financial expert (if designated) is independent, as the proposed financial expert disclosure requirements would require. While this disclosure may make sense for Operating Companies, its effect when applied to Funds would be merely to repeat disclosure available elsewhere. In practice, Fund audit committees are already composed solely of independent directors. Also, detailed information about Fund directors is already disclosed in Fund Statements of Additional Information ("SAIs"). Since the financial expert is expected to be a member of a Fund's audit committee, it follows that he or she would be independent, and this independence would be disclosed in the Fund's SAI. Accordingly, there is no need for the additional disclosure that would be required by proposed Form N-CSR.
Nonetheless, if the Commission does apply this disclosure requirement to Funds in its final rule, in our view, the standard of independence should be modified for investment companies. Creating a hybrid definition to be used solely for purposes of meeting the disclosure requirements of proposed Form N-CSR is unnecessarily confusing.15 Instead, the Commission should use the standard that Congress has devised specifically for Funds: that found in Section 2(a)(19) of the ICA.
II.Proposed Code of Ethics Disclosure Requirement
The Commission has proposed to require Operating Companies, Funds and UITs to disclose whether they have adopted codes of ethics that cover both principal executive officers and senior financial officers, and if not, why not. The Commission has proposed to define a "code of ethics" as a code of conduct that is reasonably designed to deter wrongdoing and to promote:
Registered investment companies would be subject to a broader disclosure requirement than would Operating Companies. The Commission has proposed that a registered investment company disclose annually whether the investment company's investment adviser, and its principal underwriter, as well as the investment company itself17 (each, a "Code of Ethics Entity") have adopted written codes of ethics that apply to their respective principal executive, financial, and accounting officers or controllers, or other persons performing similar functions. Funds also would be required to include any written code of ethics and amendments to that code of ethics as an exhibit to the investment company's reports on Form N-CSR. UITs would be required to include any written code of ethics and amendments to that code of ethics as an exhibit to the investment company's reports on Form N-SAR. A registered investment company would be required to disclose any amendments to or waivers from a Code of Ethics Entity's code of ethics in the registered investment company's next-filed Form N-CSR or N-SAR, or on its website within two business days after the amendment or waiver.
A. Existing Regulations Already Inhibit Conflicts of Interest.
We submit that the proposed rules relating to codes of ethics disclosure requirements (the "Proposed Code of Ethics Rules") would be redundant and unhelpful as applied to a registered investment company. The Commission stated that a comprehensive code of ethics should set forth guidelines requiring avoidance of conflicts of interest and material transactions or relationships involving potential conflicts of interest without proper approval.
Operating companies' transactions involving conflicts of interest are typically governed by state corporate law. The Delaware General Corporation Law and the Model Business Corporations Act ("MBCA") each provide that no contract or transaction is voidable solely because a corporate officer or director has a financial interest in the transaction, as long as:
By contrast, Section 10(f) of the ICA restricts the ability of a Fund to buy securities during the existence of an underwriting in which an affiliate participates as an underwriter; and Section 17 of the ICA goes well beyond disclosure, flatly prohibiting the vast majority of principal transactions between investment companies and their affiliated persons, principal underwriters or promoters, as well as affiliated persons of such entities. For example:
One commenter has observed that "[s]ection 17 overturns the common law rule that fiduciaries may deal with their beneficiaries provided disclosure is made, since the evidence in 1940 indicated that this rule was inadequate to protect investment company shareholders."19 Thus, the ICA prohibits outright many of the conflicts of interests that would be covered by a typical code of ethics of an Operating Company.
Funds are already required by Rule 17j-1 under the ICA to have codes of ethics in place. These codes already protect Funds and their investors, and unlike the codes of ethics referred to in the Proposed Code of Ethics Rules, these codes are mandated by law. The Commission correctly noted that Rule 17j-1 codes of ethics are designed to prevent fraud resulting from personal trading in securities by portfolio managers and other employees. It is true that these codes are not as broad as the codes of ethics envisioned in the Proposed Code of Ethics Rules would be.
However, in our view, a code of ethics would provide little added benefit while introducing duplicative and possibly contradictory directives to the principal executive officers and principal financial officers of a Code of Ethics Entity. The ICA sharply limits the types of conflicts of interest that can arise in the Fund context. In our view, a Rule 17j-1 code of ethics effectively addresses the single most significant remaining conflict of interest that may arise in the Fund context. Imposing an additional code of ethics on the Fund industry is unnecessary and would add nothing in the way of investor protection.
B. The Additional Disclosure That Would Be Required by the Proposed Code of Ethics Rules Will Not Provide Additional Investor Protection, But Will Result in Increased Fund Costs to the Ultimate Detriment of Fund Shareholders.
Requiring a Fund to make the disclosures contemplated in the Proposed Code of Ethics Rules as to the existence of, application of, and compliance with a code of ethics by its Code of Ethics Entities will not benefit the investing public in any substantive respect. As discussed above, several provisions of the ICA and the rules promulgated thereunder already effectively prevent conflicts of interest and fraudulent activity. Instead of contributing additional protection, the Proposed Code of Ethics Rules would simply increase the Fund's expenses and diminish its returns.
C. The Proposed Code of Ethics Rules Can Also Be Expected to Increase a Fund's Litigation Risk.
We note that the Proposed Code of Ethics Rules would allow a Fund to choose not to adopt a code of ethics, as long as it discloses that it has not done so and explains why it has not. Funds may be reluctant to take this course of action, for the same reasons that Funds may be reluctant not to designate a financial expert. A Fund that did not adopt a code of ethics as defined in the Proposed Code of Ethics Rules would be subjecting itself to amplified risk of litigation. Just as plaintiffs and their attorneys would be likely to attack a Fund board that does not designate a financial expert, they also could attack the reasonableness of a Fund board's decision not to adopt a code of ethics. At least in theory, plaintiff's attorneys could allege that failure to adopt such a code was an unreasonable decision and contributed to a Fund's financial difficulties. Furthermore, it is unfair to require Funds to assume the risk that their disclosure regarding the existence of an investment adviser's or principal underwriter's code of ethics, or any amendments or waivers to those codes of ethics, is inaccurate. This issue has particular relevance for Funds employing sub-advisers. The Commission staff has recognized that a Fund's sub-adviser does not ordinarily control a Fund.20 Yet, the Commission's rules would require a Fund to assume the risk that disclosure regarding a sub-adviser's code of ethics is inaccurate or misleading.
D. The Commission in its Final Rules Should Track the Language of the Statute as Closely as Possible, to Avoid Imposing any Unnecessary Additional Burden on Funds.
Unfortunately, as noted above, the language of the Act may make it impossible for the Commission to exempt Funds from the code of ethics disclosure requirements.21 If that is the case, however, we urge the Commission to adopt final rules that track the language of the Act as closely as possible, to avoid any unnecessary burden or expense being imposed on Funds and their boards.
We strongly support the adoption of a final rule that applies the code of ethics requirements only to senior financial officers, as Congress specifically required in the Act. Had Congress intended principal executive officers to be included within the scope of the Proposed Code of Ethics Rules, it could easily have done so. The terms "principal executive officers," "chief executive officer" and "executive officer" are sprinkled throughout the Act. It may indeed be true, as is suggested in the proposing release for the Proposed Code of Ethics Rules, that it is appropriate to apply the code of ethics requirements to the principal executive officers of an Operating Company, even though Congress did not expressly cover them in the Act. However, applying the Proposed Code of Ethics Rules to principal executive officers of a registered investment company will serve no purpose.22 Similarly, we find it unnecessary to broaden the definition of "code of ethics" found in the Act. The definition is crafted in such a manner as to be sufficiently broad, yet narrow enough so that registered investment companies and Operating Companies can recognize whether their codes of ethics meet the statutory definition. To minimize the burden on registered investment companies, we believe that the Commission should track the language of the Act in its final rule.
E. Funds Should Be Allowed the Same Reporting Time Frame for Waivers and Amendments Disclosure Over the Internet as They Are Allowed in Form N-SAR or Proposed Form N-CSR.
The Commission's proposed approach of requiring Funds to report code of ethics information on proposed Form N-CSR or Form N-SAR may enable the Fund to minimize its costs. We are concerned, though, that the Commission has proposed two different time frames for the two methods of reporting. The two standards, allowing a Fund up to six months for disclosure via Form N-SAR or proposed Form N-CSR23, and only two days for online disclosure, are so widely variant as to be incomprehensible. We do not understand why the decision to use a different disclosure method should justify such different time limits. Having a different time standard for Internet reporting may confuse the public and may also serve as a disincentive to making these disclosures over the Internet. A Fund that chooses to make its disclosures online should be given the same amount of time to disclose an amendment or waiver as a Fund that chooses to disclose this information in Form N-SAR or proposed Form N-CSR. This issue has particular relevance for Funds that employ sub-advisers. A Fund may not receive notification from a sub-adviser that it has amended or granted a waiver from its code of ethics. Consequently, it may not be able to meet the two day time frame contemplated by the Commission, through no fault of its own.
III. Clarifications in Final Rules
Finally, we note that the Commission has suggested that companies blend their existing Rule 17j-1 codes of ethics with the code of ethics referenced in the Proposed Code of Ethics Rules. The Commission stated that combining the two codes would be much more convenient for registered investment companies and much less confusing for Code of Ethics Entities. In our view, however, the convenience afforded the Fund by the ability to merge the two codes of ethics is accompanied by a grave concern. One could interpret the reporting requirements outlined in the Proposed Code of Ethics Rules as being applicable to the entire combined code of ethics (including those provisions that are required only by Rule 17j-1 and those provisions that a Fund voluntarily includes in its code). However, the release proposing the Proposed Code of Ethics Rules did not clearly state that this is the case. We hope that the Staff will clarify in its final rule release that the waivers and violations disclosure would apply only to the provisions of these codes that are implemented in response to the Act.
Furthermore, combining the two Codes of Ethics could subject the code of ethics to liability under the Securities Act of 1933, given that the Commission requires Rule 17j-1 codes of ethics to be filed as exhibits to Funds' registration statements. In addition, it is unclear whether the disclosure provisions of the Proposed Code of Ethics Rules should apply only to those provisions of a combined code of ethics that are adopted pursuant to the proposed rules, or whether the disclosure provisions would subject the entire combined Code to the liability provisions of Section 18 of the 1934 Act. We respectfully submit that the Commission clarify in its Final Rules that the disclosure provisions would not apply to the Rule 17j-1 portion of a combined code of ethics.
Finally, we note that the Proposed Code of Ethics Rules do not mention whether a private right of action may be maintained for violations. By contrast, the Commission specifically noted that the proposed rules to prohibit improper influence on the conduct of audits do not give rise to a private right of action. We believe that neither the Act nor the Commission intended to imply a private right of action with regard to the Proposed Code of Ethics Rules or the Proposed Financial Expert Disclosure Rules. Nonetheless, plaintiff's attorneys could try to make a case for the existence of such a right of action. This would be less likely if the Final Rules clarified that no private right of action exists under the rules.
We appreciate having the opportunity to comment on these proposals. If you have any questions or require additional information about our comments, please feel free to contact Jack W. Murphy at 202.261.3303 or Ethan D. Corey at 202.261.3304.
cc: Paul F. Roye
Division of Investment Management