Investment Company Institute
November 27, 2002
Mr. Jonathan G. Katz
Re: Disclosure Required by Sections 404, 406, and 407 of the
Dear Mr. Katz:
The Investment Company Institute1 appreciates the opportunity to comment on the Securities and Exchange Commission's proposal to implement the requirements in Sections 404, 406, and 407 of the Sarbanes-Oxley Act of 2002 (the "Act").2 The Commission's proposal would require investment companies to provide disclosure with respect to members of their audit committees determined by the board of directors to be "financial experts" and disclosure with respect to codes of ethics for investment company principal executive officers and senior financial officers.3 In addition, the proposal would make various "technical changes" to the Commission's rules and forms implementing Section 302 of the Act for registered investment companies to conform to rule changes it is proposing for operating companies.
In summary, the Institute's comments are as follows:
Each of these comments is discussed more fully below.
I. Disclosure Regarding Audit Committee Financial Expert
A. Scope of the Definition of "Financial Expert"
To implement Section 407 of the Act for investment companies, the Commission has proposed adding a new disclosure item to proposed Form N-CSR that would require a registered management investment company to disclose annually: (i) the number and names of persons that the board of directors has determined to be the financial experts serving on the investment company's audit committee; (ii) whether the financial expert(s) are independent, and if not, an explanation of why they are not; and (iii) if the investment company does not have a financial expert serving on its audit committee, the fact that there is no financial expert and an explanation of why it has no financial expert. 4
The Commission's proposal would use the same definition of "financial expert" for investment companies that it is proposing to adopt for all other companies (except with respect to a factor relevant to foreign private issuers). In each case, financial expert would be defined to mean a person who has:
several attributes, including:
The Proposing Release requests comment on whether the definition should be modified for investment companies. We strongly believe that it should. More specifically, we recommend that the Commission revise the proposal with respect to investment companies so that: (i) a director could be found to be a financial expert based on a qualitative assessment of that person's education and/or experience, which would not necessarily include experience as a public accountant or auditor or a principal financial officer, controller, or principal accounting officer of a company; and (ii) three elements of the definition proposed by the Commission -- namely, a director's experience with applying GAAP in connection with the accounting for estimates, accruals, and reserves, a director's experience preparing or auditing financial statements, and a director's experience with internal controls and procedures for financial reporting -- would be factors to be considered, rather than requirements that must be met in all cases. The reasons for these recommendations are discussed below.
First, investment company financial statements are inherently simpler than operating company financial statements given the structure and operation of investment companies and the nature of their assets and liabilities, income and expenses, and the related accounting policies. Unlike operating companies, the assets of investment companies consist exclusively of investment securities. Gains and losses on investment securities are determined daily by reference to readily available market prices. Liabilities typically relate to fees payable to service providers for services received, and amounts payable to settle transactions in portfolio securities and fund shares. Investment income consists primarily of dividends and interest on portfolio securities. Dividend income is recognized on the security's ex-dividend date, while interest income is accrued daily. Fund expenses are accrued daily and generally are based on contract fee rates. Fund accounting policies, which are described in the financial statement footnotes, reflect the circumscribed nature of fund assets, income and expenses.5
Investment companies do not engage in the types of transactions that gave rise to the financial reporting and audit failures that the Act is intended to address. Investment companies do not have off balance sheet arrangements, do not form special purpose entities, and do not report "pro forma" earnings. Congress recognized this when it exempted registered investment companies from Section 401 of the Act. Moreover, investment companies do not engage in "channel stuffing" or "bill and hold" type schemes intended to overstate revenues. They do not capitalize line costs as assets in order to understate expenses. Indeed, because of the nature of their assets, liabilities, income and expenses, they do not have the opportunity to engage in these types of schemes. Furthermore, we are not aware of any misapplication of GAAP, internal controls, or auditing standards that necessitated restatement of investment company financial statements.
As the Commission itself points out in the Proposing Release, "the more complicated the business, the greater the need for a higher threshold of financial expertise."6 The logical corollary to this proposition is that in the case of a less complicated business, a broader definition of financial expertise would be appropriate.
Second, the proposed definition in its current form would inappropriately limit the pool of candidates potentially qualified to serve as investment company financial experts, and would force almost all investment companies to add new directors if they wish to have a financial expert meeting that definition. In particular, several distinct aspects of the proposed definition of financial expert, noted above, have the effect of limiting qualified candidates to current or former corporate accounting staff members, chief financial officers, auditing professionals or others with the requisite experience through similar employment.7 Due, in part, to the straightforward nature of fund financial statements and accounting policies, investment company audit committees typically do not include directors with the requisite experience, such as chief financial officers or former auditors. Rather, audit committees for investment companies typically have members with relevant investment company experience or other appropriate business experience. These persons can serve very effectively in the role of "financial expert" which, as the Commission specifically recognizes, is "to assist the audit committee in overseeing the audit process, not to audit the company."8
Examples of additional positions that we believe would provide relevant knowledge and experience to an investment company "financial expert" include the chief operating officer and other officers of a public or private company, a business school professor, a financial analyst, or a person with experience in managing investments or in investment company operations. Such persons could be expected to have an understanding of GAAP and audit committee functions, consistent with the factors set forth in Section 407(b)(1) and (4) (and the corresponding requirements in proposed Instructions 2(a) and (2)(e) to Form N-CSR). Persons who do not necessarily have the specific types of experience identified by the Commission, including preparing or auditing financial statements, should not be disqualified from serving as financial experts if they have the requisite financial sophistication to be a valuable resource for an investment company audit committee.9
Indeed, a review of the qualifications of several independent directors who currently serve on fund audit committees but who would not qualify as "financial experts" under the Commission's proposed definition demonstrates the short-sightedness and impracticality of the proposed approach. Persons who would not be considered "financial experts" include a retired chairman of the board of a bank holding company, a former chief executive officer of an international public company, a retired president and chief operating officer of a public company, a former president and chief operating officer of a publicly owned insurance company, a former president of a financial counseling firm, a co-chief executive officer of a private investment company, a co-founder of a private and public equity market investment firm, the chief investment officer and managing director of a financial institution that manages fixed income portfolios for institutional clients, and a retired brokerage firm executive. Under our proposed approach, these persons could qualify as financial experts, assuming they met the other criteria set forth in the Commission's proposal.
Limiting the pool of qualified candidates to persons with the enumerated types of experience also is inconsistent with the Commission's assertion in the Proposing Release that, in determining if a person is a financial expert, an investment company's board of directors "must evaluate the totality of an individual's education and experience."10 Moreover, such a limitation is at odds with the Commission's recognition that "[s]ome individuals who are particularly knowledgeable and experienced in accounting and financial issues may have the requisite attributes and mix of knowledge and experience to qualify as financial experts, even though they may not have served in one of the specifically identified positions. The board of directors would have to determine whether an individual's qualifications, in the aggregate, satisfy the financial expert definition."11 We believe that investment company boards should be permitted to assess an individual's qualifications and determine that a person is a financial expert even if that person does not have all of the enumerated types of experience. The recommended approach would be consistent with the Commission's traditional approach of relying on fund boards to use their judgment in representing fund investors and protecting their interests.12
For the reasons stated above, the Institute recommends that the Commission revise the definition of "financial expert" for investment companies in the manner described above so that experience preparing or auditing financial statements and the other specific types of experience enumerated in the Commission's proposal would not be prerequisites for an investment company director to be considered a financial expert.13 Our recommended approach is fully consistent with the language and purpose of Section 407 of the Act, which directs the Commission to define the term "financial expert" and directs the Commission to "consider" various factors in developing this definition. In so directing the Commission, as we previously indicated, we believe that Congress provided the Commission with the needed flexibility to determine the relevance of particular factors for different kinds of issuers.14 In the case of investment companies, the required experience simply does not have the same degree of relevance that such experience may have in other contexts. Not only is it unnecessary to require such experience to fulfill Congress's intent to inform shareholders as to whether at least one audit committee member has relevant financial expertise to discharge his or her duties,15 but also such a requirement would have the unfortunate effect of forcing investment companies to either make disclosure that raises unjustified negative implications or incur the time and expense associated with recruiting new directors without any significant benefit for investment company shareholders.16
B. Financial Expert Liability
The Proposing Release provides that the "mere designation of the financial expert should not impose a higher degree of individual responsibility or obligation on a member of the audit committee" and that the Commission does not intend for the identified financial expert to be an "expert" for the purposes of Section 11 under the Securities Act. We agree with and support the Commission's views in this regard. In particular, as noted above, we believe that if being identified as a financial expert entails a greater liability risk, then companies will have much greater difficulty finding qualified individuals who are willing to be so identified.
There is a risk, however, that these statements in the Proposing Release may not provide a sufficient basis for federal or state courts to reach the same conclusions. For example, as a matter of statutory interpretation, courts might determine that the expertise possessed by a financial expert should be considered in applying the scienter requirements of a Rule 10b5-1 claim or the "reasonable ground" component of a "control person" claim under Section 15 of the Securities Act, or in determining the director's status as an "expert" under Section 11 of the Securities Act. In addition, courts applying state law "duty of care" concepts might consider an identified financial expert's experience and skills to impose greater obligations. These courts might not find that the stated intention of the Commission in a proposing release overrides the statutory or common law basis for their conclusions.
We suggest that the Commission take additional steps to give legal and practical effect to its view that identification as a financial expert should not increase individual responsibility, obligation or liability. The Commission could accomplish this by including a statement in the instructions to proposed Sub-Item 102P3 of Form N-SAR and proposed Item 4 of Form N-CSR that no issuer or director shall be subject to any additional liability under the federal securities law as a result of the disclosure required by those Items. We believe that including this statement in a form promulgated by the Commission would have greater legal and practical effect than merely including similar statements in the proposing or adopting release, particularly in light of Section 19(a) of the Securities Act, Section 23(a)(1) of the Exchange Act and Section 38(c) of the Investment Company Act, each of which provide that liability under the respective acts will not be imposed for any act done in good faith in conformity with any rule, regulation or order of the Commission.
Furthermore, if it is the view of the Commission that additional liability should not be imposed on a director merely due to his or her identification as a financial expert, then presumably the Commission would not view indemnification or insurance for any such additional liabilities that are, in fact, imposed to be contrary to public policy. Therefore, we suggest that the Commission amend accordingly those of its rules that require issuers to include language in public filings relaying the Commission's view on the unenforceability of such indemnification or insurance agreements.17
C. Transition Period
Although neither Section 407 of the Act nor the Commission's proposal would require investment companies to have financial experts on their audit committees, many funds may wish to do so to avoid making disclosure that may raise unwarranted negative implications as to the expertise of audit committee members. Depending on the details of the final disclosure requirement, many investment companies may seek to recruit new directors to serve in the capacity of "financial expert." The Proposing Release recognizes this possibility, and requests comment on whether the Commission should provide companies with a transition period to find a financial expert and, if so, what would be an appropriate period.18
The Institute strongly recommends that, before requiring investment companies to comply with a new disclosure requirement regarding financial experts, the Commission provide investment companies with adequate time to determine whether to have financial experts on their boards, and for those that decide to do so, to recruit and adequately vet individuals that meet the definition of "financial expert."19 In particular, we request that investment companies be required to comply with any new requirements with respect to financial experts in the next Form N-CSR filed on or after a specified date, which date would be eighteen months after the adoption of any such requirements.20 Such a transition period is consistent with the Commission's compliance date for certain new rules and rule amendments with respect to the role of independent directors of investment companies.21
II. Disclosure Regarding Codes of Ethics
A. Persons Covered by Codes of Ethics
The Commission's proposal to implement Section 406 of the Act with respect to investment companies would require registered investment companies to disclose annually whether each of the investment company, its investment adviser, and its principal underwriter has adopted a written code of ethics that applies to the principal executive officer, principal financial officer, principal accounting officer or controller, or persons performing similar functions of, respectively, the investment company, its investment adviser, and (in certain circumstances) its principal underwriter.22 The Proposing Release seeks comment on, among other things, whether the proposed code of ethics disclosure requirements cover the appropriate entities, in addition to the registered investment company itself, and on whether any entities should be removed or others added.23 As discussed below, the Institute recommends revising the universe of persons to be covered by the code of ethics to ensure that the requirements serve their intended purpose.
As an initial matter, we note that Section 406 speaks in terms of disclosure regarding an issuer's code of ethics and its application to the issuer's senior financial officers.24 The Proposing Release points out that investment companies and their investment advisers and principal underwriters currently are required by Rule 17j-1 under the Investment Company Act to adopt codes of ethics with respect to personal trading in securities by portfolio managers and other employees.25 It further states that the proposed code of ethics disclosure requirements would generally cover the same entities covered by Rule 17j-1, "because these are the entities with respect to which conflicts of interest and other ethical issues are most likely to arise."26 By taking this approach, however, the Commission's proposal goes beyond its appropriate scope. For example, in some instances the proposal would subject to the code of ethics requirements officers or other employees of an investment adviser or principal underwriter who have no involvement in the investment company's operations or financial reporting.
The Institute does not believe this result is contemplated by Section 406 or warranted for any other reason. While we recognize that investment companies typically do not have their own employees, and that their operations are carried out by a variety of service providers, we do not believe this necessitates or justifies extending the reach of the code of ethics requirements to all of the persons who would be covered under the Commission's proposal.27 We therefore recommend that the Commission revise its proposal with respect to investment companies so that for purposes of Section 406, the persons required to be covered by the code of ethics would be the investment company's principal executive officer, principal financial officer, principal accounting officer or controller, or persons performing similar functions for the investment company, regardless of which entity employs these individuals.28 Thus, rather than considering which entities should be covered, our recommended approach, consistent with the intent and wording of Section 406, would focus on individuals and their roles with respect to the investment company.29
B. Design of Codes of Ethics
Under the Commission's proposal, companies would be permitted to design their own codes and to develop procedures to ensure compliance with those codes. The Institute strongly supports this approach. We believe that it is critical for the Commission to permit individual organizations to address conflicts of interest and other matters to be covered by the code through the development of specific requirements and compliance oversight that is tailored to their individual circumstances. Because the organizations themselves are the most familiar with their specific needs and circumstances, they are in the best position to design an effective code. For example, some investment companies may choose to develop a new code of ethics (distinct from their existing codes of ethics developed pursuant to Rule 17j-1 under the Investment Company Act), while others may incorporate any new code of ethics provisions into an existing Rule 17j-1 code. 30 We believe this kind of flexibility is necessary and appropriate. Therefore, we support the Commission's proposed approach to permit investment companies to decide how to best implement new code of ethics requirements.
C. Disclosure of Waivers and Amendments
Under the proposal, if the investment company, its investment adviser, or its principal underwriter has, during the period covered by the report, amended, or granted a waiver from, the new code of ethics, the investment company's report on Form N-SAR or Form N-CSR, as applicable, would have to provide a brief description of the amendment or waiver. In the alternative, the investment company would be permitted to disclose this information on its website within two business days after the occurrence of the waiver or amendment, if it complied with certain conditions.31 The Institute supports the proposed approach and does not believe that the Commission should require investment companies to use Form 8-K (or a new form for the reporting of this information) to disclose amendments to, or waivers from, codes of ethics. We do not believe it is necessary or appropriate to establish a new reporting regime for investment companies simply to provide more frequent reporting of this information.
Under the proposal, an investment company would be required to disclose any waiver, including an "implicit waiver" 32 from its code of ethics.33 The Proposing Release seeks comment on whether a waiver is a sufficiently distinct and formal event that will not present difficulties of interpretation.34 Comment also is sought on whether the proposed requirement should be modified to ensure that "de facto, post hoc" waivers are reported.35
The Institute is concerned that the terms "waiver," "implicit waiver" and "de facto, post hoc waiver" all are susceptible to difficulties of interpretation. We recommend that the Commission clarify that the waivers required to be disclosed are those that involve action (i.e., an express grant of permission) or inaction on the part of a company with respect to a reported or known violation of a code provision,36 either before or after the occurrence of such violation. We believe that this description would more clearly define the scope of the requirement and would address the Commission's concern with ensuring that "de facto, post hoc" waivers of known or reported violations are disclosed. Further, the Commission should clarify that it would not view a waiver to have occurred if a penalty is imposed on an employee who violates the code of ethics.37 The requested clarifications are necessary to prevent companies from unwittingly violating the disclosure requirement with respect to waivers.
D. Transition Period
We request that the Commission provide investment companies with adequate time to develop new or modify existing codes of ethics and to put into place the appropriate compliance procedures needed to administer these requirements before being required to comply with a new disclosure requirement regarding codes of ethics. As with the financial expert provisions, although investment companies will not be required to have new codes of ethics, many funds will view this as a practical necessity to avoid making disclosure that may raise unwarranted negative implications as to the integrity of the company and its officers. Therefore, we request that compliance with any new requirements with respect to codes of ethics not be required until twelve months after the effective date of such requirements. The requested transition period would be consistent with the Commission's compliance date for the most recently adopted amendments to Rule 17j-1.38
III. Technical Changes to Rules and Forms Implementing Section 302
Pursuant to Section 404 of the Act, the Commission's proposal would require each company that files an annual report under Section 13(a) or 15(d) of the Securities Exchange Act to include an internal control report that states management's responsibilities for establishing and maintaining internal control procedures for financial reporting, and that assesses the effectiveness of such controls and procedures. Recognizing that Section 405 of the Act specifically excludes registered investment companies from Section 404, the Commission notes its intent not to propose any rules that would implement Section 404 with respect to registered investment companies.39 Instead, the Commission's proposal would amend various rules and forms implementing Section 302 of the Act for registered investment companies in order to conform those rules to the rule changes that it has proposed for operating companies. In particular, the Commission's proposal would: (1) require an investment company's principal executive officer and principal financial officer to state that they are responsible for establishing and maintaining internal controls and procedures for financial reporting; and (2) require the evaluation of the effectiveness of the investment company's disclosure controls and procedures as of the end of the period covered by the report. As discussed below, the Commission's proposal raises several issues for investment companies.
A. Requirement to Establish, Maintain and Design Internal Controls and Procedures for Financial Reporting
Proposed paragraph (b)(4) of Rule 30a-2 under the Investment Company Act would require an investment company's principal executive officer and principal financial officer to certify that they are responsible not only for establishing and maintaining disclosure controls and procedures, but also for establishing and maintaining internal controls and procedures for financial reporting. In addition, proposed subparagraph (b)(4)(ii) would require the certifying officers to certify that they have designed, or under their supervision caused the design of, such controls and procedures to provide reasonable assurances that the investment company's financial statements are fairly presented in conformity with generally accepted accounting principles.
The Institute strongly opposes this part of the Commission's proposal. Requiring an investment company's certifying officers to certify that they are responsible for establishing, maintaining and designing their firm's internal controls and procedures for financial reporting essentially would subject investment companies to requirements included in Section 404 of the Act.40 This result directly contravenes Section 405 of the Act which, as noted above, exempts registered investment companies from Section 404.41 Although the Commission's proposal purports to amend various rules and forms implementing Section 302 of the Act, ostensibly for the purpose of making conforming amendments to its proposed rules for operating companies, in fact, the proposal would require an investment company's certifying officers to make statements relating to the "responsibility of management for establishing and maintaining an adequate internal control structure and procedures for financial reporting."42 As such, the proposed amendments, in effect, would apply Section 404 to investment companies through the "back door." It would be wholly inappropriate for the Commission to impose a requirement on investment companies when Congress deliberately determined not to do so. Accordingly, we urge the Commission not to adopt these proposed changes.43
B. Evaluation Periods for Disclosure Controls and Procedures
Under recently adopted Rule 30a-2(b)(4)(ii) and proposed Rule 30a-3 under the Investment Company Act, an investment company must conduct an evaluation of the effectiveness of the firm's disclosure controls and procedures within 90 days prior to the filing date of the report. As noted in the Proposing Release, when the Commission adopted the certification rules implementing Section 302 of the Act, it stated that "a single evaluation of the effectiveness of the disclosure controls and procedures for a series fund or family of investment companies could be used in multiple certifications for the funds in the series or family, as long as the evaluation had been performed within 90 days of the date of the certified report."44 The Commission's current proposal would modify this provision by eliminating the 90-day evaluation period and requiring instead that the evaluation occur as of the end of the period covered by the report.
The Commission has requested comment on the effect of this proposal on the ability to use a single evaluation for a series fund or family of investment companies where the funds have different fiscal years. As discussed below, the proposal would seriously undermine a fund complex's ability to use a single evaluation for multiple certifications. Thus, although the Proposing Release describes the proposed change as "technical" and states that the Commission has proposed it to conform the rules for investment companies to the proposed amendments for operating companies, when applied to investment companies this change is quite substantive and, if adopted, would impose an undue and unfair burden on them.
An investment company complex typically consists of many funds, which often have staggered fiscal year ends that occur throughout the year. Under the current 90-day evaluation period provision and the Commission's related guidance noted above, an investment company complex would conduct an evaluation of its disclosure controls and procedures a maximum of four times per year. This evaluation period would cover the controls and procedures applicable to all of an investment company complex's funds that have fiscal year ends occurring during the most recent 90-day period. This pragmatic approach recognizes that the disclosure controls and procedures of an investment company complex apply to all of the funds within the complex and enhances the efficiency of the process.
The Commission's proposed change, however, would severely limit the use of a single evaluation for multiple certifications inasmuch as it would require an investment company complex to conduct an evaluation in every month in which any fund's fiscal year end occurs, thus extending the number of required evaluations from a maximum of four times per year to as many as twelve times per year. Requiring an investment company complex to evaluate its disclosure controls and procedures on a more frequent basis than is presently required would be unnecessary and unjustified. It is our understanding that a complex's control environment simply does not change so often as to warrant such frequent evaluations. More importantly, complying with such a requirement would be overly burdensome for investment company complexes, particularly given that in many cases the evaluation process will involve numerous service providers who will be called upon to provide "sub-certifications" for each of the funds within the complex. 45 The time and resources involved in coordinating all of this activity on a monthly basis would be extremely costly, inefficient, and operationally disruptive, and would provide no greater protection to shareholders than the current 90-day evaluation period provides. In fact, requiring such frequent evaluations could undermine the purpose of the requirement by greatly compressing the time investment company complexes would have to perform a comprehensive review and analysis. Finally, imposing this requirement on investment company complexes would disproportionately disadvantage them compared to operating companies, which would conduct such an evaluation far less frequently. We do not believe that the Commission's proposal was intended to cause such a result.
For all of these reasons, we strongly oppose the proposed change and urge the Commission to retain the current 90-day evaluation period provision, which would enable an investment company complex to evaluate the disclosure controls and procedures applicable to its funds on a more appropriate basis.
* * * * *
The Institute appreciates your consideration of our views on these important matters. If you have any questions regarding our comments or would like additional information, please contact the undersigned at 202/326-5815.
cc: Alan L. Beller, Director
Giovanni P. Prezioso, General Counsel
Paul F. Roye, Director