Investment Company Institute
April 15, 2003
Mr. Jonathan G. Katz
Re: Proposed Amendments to NASD Rules Regarding Board Independence and
Dear Mr. Katz:
The Investment Company Institute1 is pleased to comment on Nasdaq's proposed corporate governance reforms.2 We commend the National Association of Securities Dealers, Inc. and its subsidiary, The Nasdaq Stock Market, Inc., for taking steps to improve corporate governance standards by enhancing the role of independent directors on board committees. The Institute's perspectives on the proposal are unique in that investment companies are both investors in and issuers of securities. As investors, the Institute strongly supports the objectives of the proposal -- to enhance investor confidence in the companies that list on Nasdaq, to empower independent directors to more effectively carry out their responsibilities, and to enhance the effectiveness of audit committees. Our specific comments on the proposal focus on its application to investment companies as issuers.
The proposal would apply to all listed companies, including closed-end investment companies and exchange-traded investment companies. We strongly recommend that the proposal be modified so as not to apply to investment companies in some instances and clarified with respect to investment companies in certain other respects. These changes would make the proposal more consistent with recent actions by the New York Stock Exchange and the SEC regarding corporate governance.3 We believe these changes are necessary in view of existing regulatory requirements for investment companies that satisfy many of Nasdaq's policy goals and in order to harmonize various regulatory requirements regarding audit committees.
Investment companies are regulated very differently from operating companies in that they are subject to detailed, substantive regulation under all four of the major federal securities laws. Most importantly, investment companies must register under the Investment Company Act of 1940. The Investment Company Act, in contrast to the other federal securities laws that take a more disclosure-oriented approach, imposes stringent requirements and prohibitions on the structure and day-to-day operations of investment companies. The core objectives of the Investment Company Act are to: (1) ensure that investors receive adequate, accurate information about the investment company; (2) protect the physical integrity of the company's assets; (3) prohibit or regulate forms of self-dealing; and (4) restrict unfair and unsound capital structures. In order to help achieve these objectives and to further ensure that investment companies are being operated in the interests of shareholders, the Act requires investment company boards to be comprised of a minimum percentage of independent directors.
The requirements under the Investment Company Act pertaining to fund directors were enhanced by SEC rule amendments adopted in 2001 requiring that, in most instances, at least a majority of an investment company's board of directors be independent of its investment adviser and that independent directors select and nominate other independent directors.4
Given the regulatory requirements already applicable to investment companies, we believe that much of Nasdaq's proposal either should not apply to investment companies or should be tailored in its application to investment companies, e.g., by permitting existing regulatory requirements or industry practices to substitute for the proposed listing requirements.
Our specific comments on Nasdaq's proposal are set forth below.
I. Definition of "Independent Director"
Proposed interpretive material accompanying with respect to the definition of "independent director" NASD Rule 4200 would state that a board of directors has a responsibility to make an affirmative determination that in order to be considered "independent" a director does not have a relationship with the listed company that would impair his independence. In addition, certain relationships identified in Rule 4200 would preclude a board finding of independence.5 The Proposing Release states that it is important for investors to have confidence that individuals serving as independent directors do not have a relationship with the listed company that would impair their independence.6
The Institute recommends that the proposal be modified to clarify that whether a director of an investment company is independent should be determined exclusively under the provisions of Section 2(a)(19) of the Investment Company Act, which imposes strict standards for measuring the independence of investment company directors. These requirements are stricter in certain respects than those identified in the proposal, and are tailored to the types of conflicts of interest faced by investment company directors. 7 Using the Investment Company Act definition would satisfy Nasdaq's policy goals while avoiding the imposition of two different standards.
II. Nomination of Directors
Under the proposal, listed companies would be required to have a majority of their independent directors, or a nominations committee comprised solely of independent directors, nominate directors. According to the Proposing Release, independent director oversight of nominations would enhance investor confidence in the selection of well-qualified director nominees.8 We note that as a result of the SEC's investment company corporate governance rule amendments, most investment company boards already are subject to the requirement that independent directors select and nominate other independent directors. Therefore, we request that the proposal be clarified so that this requirement would not apply to investment companies if their independent directors nominate other independent directors. We do not believe that it is necessary or appropriate for investment company independent directors to be required to have sole authority to nominate "interested" directors. Our recommended approach is consistent with the Commission's investment company corporate governance rules. It would also be consistent with the NYSE's most recent recommendations regarding director nominations.9
III. Compensation of Officers
The proposal would require listed companies to have either a majority of independent directors or a compensation committee comprised solely of independent directors meeting in executive session determine the compensation of the chief executive officer and certain other officers.10 According to the Proposing Release, independent director oversight of compensation would help assure that appropriate incentives are in place, consistent with the board's responsibility to maximize shareholder value.11 We do not believe it is necessary or appropriate for this requirement to apply to investment companies.
Most investment companies are externally managed -- that is, they have a contract with an investment adviser that manages the fund's securities portfolio in conformance with the fund's stated investment objectives and policies.12 Investment companies structured in this way do not have executives comparable to those in other listed companies and, therefore, do not need the proposed oversight of executive compensation.13
In addition, the Investment Company Act has requirements that are tailored to focus the attention of investment company independent directors on potential conflicts of interest related to investment adviser compensation. Specifically, Section 15(a) of the Act makes it unlawful for any person to serve as an investment adviser except pursuant to a written contract that has been approved initially by a majority of the investment company's shareholders. Section 15(a)(2) of the Act further provides that an advisory contract can run initially for a period of no more than two years, and continue in effect thereafter, only if the board annually approves it. Moreover, Section 15(c) of the Act requires that the advisory contract and any renewal thereof be approved by a majority of the independent directors. This action must take place at a meeting called for the purpose of voting on such approval and the votes must be cast in person.14 As a practical matter, an investment company's independent directors typically meet outside the presence of management representatives to discuss the advisory contract.15 Moreover, investment companies are required to disclose in their Statements of Additional Information the factors the board considered in approving and reviewing the advisory contract.16 Finally, Section 36(b) of the Act imposes, as a matter of federal law, a fiduciary duty on an investment company's investment adviser with respect to the amount of compensation received from the company.
IV. Audit Committee
A. Duties of Audit Committee
1. Harmonization with Rule 10A-3
The proposal would expand the items that must be specified in a company's audit committee charter. Specifically, the following audit committee responsibilities would be required: (i) the pre-approval of all audit services and permissible non-audit services as set forth in Section 10A(i) of the Exchange Act; (ii) the sole authority to appoint, determine funding for, and oversee the outside auditors, as set forth in Section 10A(m)(2) of the Exchange Act;
(iii) the responsibility to establish procedures for complaints as set forth in Section 10A(m)(4) of the Exchange Act; and (iv) the authority to engage and determine funding for independent counsel and other advisors as set forth in Section 10A(m)(5) of the Exchange Act.17 Nasdaq explains that these requirements should enhance the effectiveness of audit committees in carrying out their responsibilities.
The Institute strongly suggests modifying the proposal so as to harmonize any new audit committee responsibilities required by Nasdaq with recently adopted Rule 10A-3.18 We believe that such an approach is appropriate because it will ease administration of the new requirements for listed companies and be more appropriately tailored for investment companies,19 while affording important investor protections. We specifically recommend that the proposal be modified so that Rule 4350(d)(1)(D) references Rule 10A-3 (rather than Section 10A(m)).20
2. Procedures for Handling Complaints
Under the proposal, audit committees would be required to establish procedures for:
(i) the receipt, retention, and treatment of complaints received by the listed issuer regarding accounting, internal accounting controls or auditing matters; and (ii) the confidential, anonymous submission by employees of the listed issuer of concerns regarding questionable accounting or auditing matters. The Institute supports the proposed requirements, particularly Nasdaq's decision to refrain from prescribing specific procedures. Given the variety of issuers and organizational structures, we believe companies should be afforded the flexibility to develop procedures appropriate for their particular circumstances. In addition, we note that this aspect of the proposal has the benefit of being consistent with Rule 10A-3.
3. Audit Committee Authority to Engage and Fund Outside Advisers
Under the proposal, an audit committee would have the authority to engage independent counsel and other advisers, as it determines necessary to carry out its duties. The Institute supports this aspect of the proposal because it will permit audit committees to perform more effectively by being able to seek advice, as appropriate, on accounting and legal matters. Moreover, we do not believe it would be appropriate for an audit committee to be dependent on management's willingness to pay for advisers that the audit committee has determined to be necessary to more effectively carry out its functions.21 Therefore, we recommend that the proposal be revised to make clear that Nasdaq-listed issuers would be required to provide appropriate funding, as determined by the audit committee, for payment of compensation to any advisers employed by the audit committee.22
B. Audit Committee Composition
1. Committee Member Independence
Under the proposal, a member of any investment company's audit committee must be independent as defined in Rule 4200, meet the criteria for independence set forth in Section 10A(m)(3) of the Exchange Act, and not own or control 20% or more of the company's voting securities (or such lower measurement as may be established by the SEC in rulemaking under Section 10A(m)). The proposal does not distinguish investment companies from other listed companies.
In contrast to the proposal, under Rule 10A-3, a member of an investment company's audit committee may not be an "interested person" of the investment company, as defined under Section 2(a)(19) of the Investment Company Act. The SEC explained in the Rule 10A-3 Adopting Release that it had substituted the Section 2(a)(19) test for the affiliation test applied to operating companies because the Section 2(a)(19) test is tailored to capture the broad range of affiliations with investment advisers, principal underwriters, and others that are relevant in the case of investment companies.23 The Institute recommends that the proposal be modified to make the same adjustment for investment companies that was made in Rule 10A-3. We believe that this is the more appropriate standard to use because it is tailored to the types of conflicts of interest faced by investment company directors.
2. Committee Member Financial Background
Under the proposal, audit committee members would be required to be able to read and understand fundamental financial statements, including a company's balance sheet, income statement, and cash flow statement, and listed companies would be required to certify that they have, and will continue to have, at least one member of the audit committee who has past employment experience in finance or accounting, requisite professional certification in accounting, or any other comparable experience or background that results in the individual's financial sophistication, including being or having been a chief executive officer, chief financial officer or other senior officer with financial oversight responsibilities. This is identical to Nasdaq's existing requirement with respect to audit committee members except that the proposal would tighten the current requirements by providing that audit committee members would be required to be able to read and understand fundamental financial statements at the time they join the board rather than having these qualifications within a reasonable period of time of joining the board.
We do not object to the proposed change and believe that it should enhance the effectiveness of audit committees if committee members are required to read and understand financial statements at the time that they join the committee (rather than within a reasonable period of time thereafter). We strongly recommend, however, that Nasdaq defer action on this aspect of the proposal so that it can harmonize its requirements with analogous NYSE requirements.24
V. Public Comment Period
The SEC provided the bare minimum, 21-day period for interested persons to comment on this significant rule proposal. As the Institute has noted several times in the past,25 such a short comment period is extremely inadequate to develop comments before the close of the comment period on such a significant rule proposal. Given the substantial resources that Congress, the SEC, and the self-regulatory organizations have devoted to improving the corporate governance structure of American companies and foreign companies listed in the United States, it seems that the SEC would wish to seek to provide "interested persons" with a bona fide "opportunity to submit ... views and arguments" concerning these proposed rule changes. Providing the public with only 21 days to comment on such a significant proposal does not constitute meaningful opportunity to comment. We urge the SEC to lengthen the public comment period for any future significant self-regulatory rule proposals.
* * * * *
We appreciate your consideration of our comments on this important proposal. If you have any questions or need additional information, please contact me at (202) 326-5815, Dorothy Donohue at (202) 218-3563, or Amy B.R. Lancellotta at (202) 326-5824.
cc: Edward S. Knight, General Counsel
Paul F. Roye, Director
Annette Nazareth, Director