U.S. Securities and Exhange Commission
Securities Act of 1933
Release No. 8346A/January 7, 2004
Investment Company Act of 1940
Release No. 26290A /January 7, 2004
File No. 3-11351
In the Matter of Jon D. Hammes, Albert Gary Shilling, Allan H. Stefl, and Linda F. Stephenson
Dissent of Commissioner Roel C. Campos
I concur with the Commission's decision to file an injunctive action against Heartland Advisors and certain of its officers, directors and employees, and with the acceptance of the settlement offer and the issuance of an administrative order making findings and imposing sanctions against FT Interactive. However, I dissent from the Commission's acceptance of the settlement offer of four independent directors of Heartland Group Funds ("Funds") in this proceeding.
As with almost all settled administrative proceedings, the findings contained in the Commission's order and the sanctions imposed were negotiated by the staff of the Division of Enforcement and counsel for the respondents prior to the institution of the proceeding. As such there is no independent evidentiary record available from which conclusions can be made. Instead the views I express in this statement are made on the basis of the information developed by enforcement staff in their investigation of this matter and considered by the Commission in its deliberative process, as well as an assumption that the staff would have been able to prove, by a preponderance of the evidence, these facts in a litigated proceeding.
While a written dissent in a settled administrative proceeding is an unusual event, I believe that the facts and circumstances and the legal issues raised make it appropriate. This case deals with a subject of great significance today, the duties and responsibilities of the independent directors of a mutual fund and the well-established fiduciary duty they owe to the investors in a mutual fund. Although the Board may have been deceived for a time by the officers and management of the Funds, the results of the SEC's investigation produced evidence indicating that the independent directors in a series of meetings from April 2000 through October 2000, received reports that made them aware that the Funds were incorrectly priced and that the Funds had insufficient liquidity to meet redemption demands. In particular the investigation indicated that independent directors knowingly, or at least recklessly:
(1) allowed Fund shares to be purchased and sold pursuant to a prospectus that contained materially false representations that assured investors that the board of directors itself would monitor the liquidity of issuers of bonds held in the fund portfolio;
(2) after learning of the mispricing, failed to require and ensure that bonds in the portfolio be properly valued and thereby misrepresented the NAV to the public;
(3) allowed an across the board haircut to the funds that was not based upon analyzing individual bond securities, causing unsupported decreases in NAV values;
(4) although it requested reports from fund management, failed to follow up and demand completion of the reports and separately ignored major findings of a third party consultant;
(5) failed to inform investors and potential investors about the illiquidity of the Fund's assets and the Fund's inability to meet redemption requests; and
(6) having become aware of mispricing and illiquidity, failed to protect fund assets for equitable distribution to all shareholders.
Of course, all settlements involve a compromise and a balancing of (i) litigation risks that not all of the investigative evidence will be established at trial, by a preponderance of the evidence, and/or that a trier of fact, or this Commission in its de novo review, may not impose stronger sanctions, (ii) the significant staff resources required to prosecute the case, and (iii) the complications of a trial having multiple defendants. However, the investigation in this case presents significant evidence, if proven at trial, of directors, having unambiguous information that funds' NAV is significantly overstated and that the funds were illiquid, failing to act in any meaningful way to protect shareholder interests.
Under our legal system, independent directors are the final and ultimate guardians of shareholder assets. As such, I believe that a case such as this should only be settled if the settlement order includes meaningful sanctions. Meaningful sanctions in my opinion would have included as a minimum: a finding of scienter-based fraud (Section 10(b) of the Securities Exchange Act, Section 17(a)(1) of the Securities Act, and Section 36(a) of Investment Company Act); a civil penalty of at least one year's director fees; and an officer and director bar of at least three years. The settlement accepted by the Commission provided for only a charge of committing "negligence" or "non-scienter-based" fraud and the only sanction imposed was an order to cease and desist from committing violations. In my opinion, the settlement accepted by the Commission sends the wrong message and diminishes the solemn obligation and duty of directors being vigilant in protecting the interests of shareholders. At a time when the Commission is initiating regulatory actions designed to reemphasize the role and responsibility of independent directors, I believe this settlement undercuts our regulatory initiatives.
Directors cannot sit idly after learning that portfolio securities are mispriced and that fund assets may not cover investors' claims. Directors particularly independent directors have a significant oversight role and monitoring responsibility, under both state law and the Investment Company Act of 1940, as well as specific responsibilities with regard to the funds' registration statement under the Securities Act of 1933. Congress and the United States Supreme Court have made clear that under the Investment Company Act, the independent directors are the guardians of shareholder interests. The Supreme Court described that role as follows:
Congress' purpose in structuring the [Investment Company] Act as it did is clear: It "was designed to place the unaffiliated directors in the role of `independent watchdogs," who would "furnish an independent check upon the management" of investment companies. . . . In short, the structure and purpose of the [Investment Company] Act indicate that Congress entrusted to the independent directors of investment companies, exercising the authority granted to them by state law, the primary responsibility for looking after the interests of the funds' shareholders.
Burks v. Lasker, 441 U.S. 471, 484-85 (1979).
Furthermore, courts have recognized a federal cause of action that overrides state standards for a violation of a fund director's fiduciary duties to shareholders under the Investment Company Act. See Brown v. Bullock, 294 F.2d 415, 421 (2d Cir. 1961). In addressing the court's jurisdiction over a claim against independent directors of a fund, the Second Circuit held, "[I]t is unreasonable to suppose that Congress would have wished to permit its purpose to protect investments in all investment companies . . . to be frustrated if [the laws of] a particular state of incorporation should be satisfied with lower standards of fiduciary responsibility for directors than those prevailing generally," and found the Investment Company Act to "create a federal body of law giving rise to a distinct federal claim."
Moreover, Section 36(a) of the Investment Company Act authorizes the Commission to bring an action against any director who has "engaged in any act or practice constituting a breach of fiduciary duty involving personal misconduct in respect of any registered investment company" and such directors may be enjoined from acting in such capacities and may be subject to other sanctions "as may be reasonable and appropriate under the circumstances, having due regard to the protection of investors and to the effectuation of the policies declared in Section 1(b) [of the Act]." 15 U.S.C. § 80a-36(a).
More particularly, while mutual fund directors are permitted by law to delegate some responsibility for pricing a fund's securities to a separate committee, each director retains responsibility to be involved in the valuation process and may not passively rely on securities valuations provided by such a committee. See In the Matter of Hartl and Lipman, Rel. No. IC-19840, 1993 WL 468571, at *4-5 (Nov. 8 1993).
Heartland Group's Board, including the Independent Directors, expressly represented in the May 1, 2000 SAI and the June 9, 2000 prospectus to shareholders that it would "monitor the issuers" of bonds held in the Funds "to assure continued liquidity" of those bonds, so that the Funds "can meet redemption requests," and therefore retained an express duty to do so. The Board admitted that it was not monitoring the liquidity of the issuers of the bonds held by the Funds.
The directors have a duty to undertake those inquiries and analyses that they represent they will undertake in the funds' filings, and their failure to undertake those actions is material and fraudulent. See In the Matter of John E. Backlund, Rel. No. IC-23634, 68 SEC Docket 2663 1999 WL 8164, at *5 (Jan. 11, 1999) (directors should have known that statements in prospectus pertaining to liquidity and value of funds' securities were false). See also In the Matter of Hartl And Lipman, Rel. No. IC-19840, 55 SEC Docket 991, 1993 WL 468571, at *5 (Nov. 8, 1993). (directors willfully aided and abetted fund's violations of antifraud provisions for material misstatement implying that directors considered various factors in valuing securities when they undertook no such independent analysis). See also In the Matter of Lloyd Blonder, Rel. No. IC-19755, 55 SEC Docket 298, 1993 WL 393615, at *3-4 (Sept. 30, 1993) (director liable for aiding and abetting fund's violations of antifraud provisions when he knew he was not reviewing the underlying financial statements of the issuers of the fund's securities or matters pertaining to the ability to sell those securities, as represented in the fund's periodic filings).
Put simply, the law in this area is well established and it is time for this Commission to hold independent fund directors fully responsible when they recklessly fail to fulfill their fiduciary duties to investors. Assuming that the staff would have been able in a litigated proceeding to prove up these facts and violations, the findings in this settled order and the sanctions imposed should have reflected the seriousness of these independent directors' misconduct. If a negotiated settlement could not be reached on this basis, I believe that the Commission and the nation's investors would have been better served by a litigated proceeding to determine the extent and egregiousness of the misconduct and the level of sanctions that are appropriate in the public interest.
They do not, and therefore, I respectfully dissent.