The Investment Company Institute
April 7, 2003
Mr. Jonathan G. Katz
Re: Implementation of Standards of Professional Conduct for Attorneys (File No. S7-45-02)
Dear Mr. Katz:
The Investment Company Institute1 appreciates the opportunity to comment on the Securities and Exchange Commission's most recent proposal to adopt minimum standards of professional conduct for attorneys appearing and practicing before the Commission in the representation of issuers.2 In particular, the proposal solicits additional comments on, and proposes an alternative to, previously proposed requirements relating to an attorney's obligation to notify the Commission when that attorney, after reporting evidence of a material violation "up the ladder" within an issuer, reasonably believes the issuer has made no response or has not made an appropriate response ("noisy withdrawal").
The Institute is pleased that the Commission deferred action on the "noisy withdrawal" provisions in order to provide interested persons with additional time to analyze and comment on the proposal. While we continue to have concerns about these provisions,3 if the Commission determines to move forward with the proposal, we strongly urge it to adopt the proposed alternative, which would require the issuer, rather than the attorney, to report to the Commission an attorney's notice, subject to our comments below.
I. "Noisy Withdrawal" Provisions
Under the "noisy withdrawal" provisions, if an outside attorney retained by the issuer, after reporting "up the ladder" within the issuer, reasonably believes the issuer has made no response or has not made an appropriate response, that attorney is required to withdraw from representing the issuer. An in-house attorney employed by the issuer, under the same circumstances, is not required to resign from his or her position. The Proposing Release specifically resolicited comment on whether an attorney who is employed by an investment adviser to an investment company and who is representing the company before the Commission should be treated as an outside attorney retained by the investment company or an in-house attorney.
As we stated in our previous comment letter, we believe that attorneys representing an investment adviser to an investment company do not jointly represent the investment company. The Commission, however, has determined that attorneys employed or retained by investment advisers that provide services to investment companies also represent such investment companies.4 Accordingly, for purposes of this provision, we believe that the Commission should treat an attorney employed by an investment adviser as an in-house attorney of the investment company. Many attorneys employed by investment advisers devote most, or all, of their time to fund-related matters. It would therefore be extremely disruptive and unnecessarily harsh to force such an attorney to resign from his or her position because of the rule.5
II. Alternative Proposal to "Noisy Withdrawal" Provisions
Under the alternative proposal to the "noisy withdrawal" provisions, the issuer, rather than the attorney, would be required to report to the Commission an attorney's notice of withdrawal or failure to receive an appropriate response. The Institute believes that the alternative proposal is preferable to the "noisy withdrawal" provisions because, at least on its face, it avoids direct conflict with an attorney's duties of confidentiality and privilege. We recommend several changes, however, to the alternative in order to facilitate compliance with the rule.
A. Determination by Committee of Independent Directors
The Commission has requested comment on whether an issuer should not be required under the rule to disclose an attorney's written notice where a committee of independent directors of the issuer's board determines, based on the advice of counsel that was not involved in the matters underlying the reported material violation, (i) that the attorney providing the written notice acted unreasonably in providing the notice, or (ii) that the issuer has, subsequent to the written notice, implemented an appropriate response.
The Institute strongly supports allowing this type of determination by a committee of independent directors. This would alleviate concerns that a single attorney would be able to compel an issuer to publicly disclose a report of a material violation in instances where disclosure is not warranted, e.g., where a material violation never occurred or the issuer's response may reasonably be deemed to be appropriate or timely. In addition, this approach is consistent with the Investment Company Act of 1940 and the rules thereunder, which already require fund advisers to regularly report information to fund boards under a governance structure that empowers directors, including independent directors, to protect fund shareholders.6 It is also common practice for funds to report material violations to their boards and to involve directors in developing an appropriate response to those violations.
We recommend, however, that several changes and clarifications be made to this provision. First, the Institute recommends that the Commission revise the standard under which the committee would have to make its determination. In particular, we recommend that the committee be required to determine whether there is substantial evidence of a material violation that is ongoing or is about to occur and is likely to cause substantial injury to the financial interest or property of the issuer or of investors (the same determination that an attorney would have to make prior to making a "noisy withdrawal") rather than whether the attorney acted unreasonably in providing notice of the material violation. We are concerned that under the proposed standard there may be instances when a committee could determine that an attorney acted "reasonably" in reporting what he or she believed to be a material violation or the failure to receive an appropriate response in a situation even when no material violation actually occurred.7 Issuer disclosure should not be required in situations where there was either no substantial evidence of a material violation of law and/or no substantial injury. Instead, issuer disclosure should be required only in circumstances where the committee concurs that there was substantial evidence of a material violation and a likelihood of substantial injury and no appropriate remedy was implemented.
In addition, we recommend that the standard by which to determine whether an issuer has implemented an "appropriate response" to the report under the proposal be revised. As defined in the rule, whether an issuer made an "appropriate response" is contingent on the beliefs of the attorney making the report.8 We believe that this part of the standard emphasizes the wrong question - whether the attorney believed the issuer made an appropriate response - and not the substantive issue - whether the independent directors have concluded that the issuer made an appropriate response. We therefore recommend that the Commission clarify that under this part of the standard, the committee must make the independent determination as to whether the issuer's response to the attorney's report was proper under the circumstances. By amending the standard in these ways, the Commission can eliminate much of the ambiguity surrounding the determination by the committee and appropriately put the decisonmaking power in the hands of the independent directors.
The Institute also recommends that the Commission clarify that directors who are not "interested persons" as defined in Section 2(a)(19) of the Investment Company Act would be considered "independent" for purposes of the rule. (The Commission adopted this concept of independence for purposes of the provisions of the rule relating to the QLCC). Similarly, we recommend that the Commission clarify that once directors qualify as "independent" for purposes of the Investment Company Act, those directors will remain "independent" for purposes of the rule.9 In addition, the Institute recommends that the Commission clarify that the independent directors on the committee will be able to rely on and will be protected by the business judgment rule. Therefore, in the absence of, for example, bad faith or gross negligence in the process by which their decisions are reached, their decisions should be protected.10
Finally, we recommend that the rule permit, rather than require, the committee of independent directors to obtain the advice of counsel in making their determination. We believe the committee should be able to use their business judgment in determining the type of advice necessary to make the required determinations under the proposal. In some situations, the committee may believe it is more appropriate to seek advice from, for example, accounting professionals or technology experts, based on the issues that are the subject of the attorney's report, rather than seek the advice of legal counsel. This determination should be left to the business judgment of the committee rather than be mandated by the Commission.11
B. Form 8-K Filing Requirement
The proposal would require an issuer that has received notice from an attorney to notify the Commission on Form 8-K within two business days of receiving the notice. The Proposing Release notes that although Securities Exchange Act Rules 13a-11(b) and 15d-11(b) generally exempt registered investment companies from Form 8-K filing requirements, the proposal would apply the same filing requirements to investment companies that it is proposing to apply to all other issuers.12 The Commission solicited comment on whether Form 8-K is the appropriate form to use for this type of disclosure or whether the Commission should adopt a new form specifically for registered investment companies.
The Institute urges the Commission not to adopt the proposed Form 8-K filing requirement for investment companies. We believe creating a new form specifically for investment companies would be more appropriate and less confusing for investment companies in meeting their disclosure obligations under the rule.
In addition, we believe that two business days after receiving notice from an attorney is not an appropriate amount of time in which to require investment companies or other issuers to make the necessary filing under the rule. The significant issue under the rule is whether an ongoing (or prospective) and potentially injurious violation of law has occurred (or will occur). Accordingly, if the provision relating to the determination by the committee of independent directors discussed above is adopted, the committee of independent directors would have to investigate the circumstances giving rise to the attorney's report and make substantive determinations. Two days is an insufficient time within which reasonably to expect the independent directors to operate. Moreover, a fixed two-day period of time does not provide the necessary flexibility to deal with various situations that may arise under the rule. For example, in the investment company context, it may require more time for the committee to investigate matters relating to an offering of securities by a closed-end fund as opposed to a question relating to a pricing error.
We therefore recommend that an issuer be required to notify the Commission "promptly" after receipt of an attorney's written notice. For these purposes, "promptly" should be defined as a reasonable period of time, depending on the specific facts and circumstances surrounding the notice, after receipt of the notice from the attorney. In order to expedite the dissemination of this information, the Commission could require the committee to begin their investigation within two business days of receipt of an attorney's notice and to file the requisite forms within two business days after completion of their investigation.
* * * * *
The Institute appreciates your consideration of our views. If you have any questions regarding our comments or would like additional information, please contact the undersigned at (202) 326-5815 or Ari Burstein at (202) 371-5408.
cc: The Honorable William H. Donaldson
Giovanni P. Prezioso, General Counsel
Paul F. Roye, Director