Speech by SEC Staff:
Enhancing the Fund Director's Tool Box
Paul F. Roye
Director, Division of Investment Management
U.S. Securities & Exchange Commission
Fourth Annual Policy Conference:
Critical Issues for Investment Company Directors
Mutual Fund Directors Forum
January 8, 2004
The Securities and Exchange Commission disclaims responsibility for any private publication or statement of any SEC employee or Commissioner. This speech expresses the author's views and does not necessarily reflect those of the Commission, the Commissioners, or other members of the staff.
Good afternoon and thank you for welcoming me here this afternoon. I am pleased to join you at the Mutual Fund Directors Forum's Fourth Annual Policy Conference and agree with Chairman Donaldson's assessment that this conference provides an important opportunity to re-examine independent director oversight of funds at this critical time for the mutual fund industry. Before I begin, I would like to remind you that my remarks represent my own views and not necessarily the views of the Commission, the individual Commissioners or my colleagues on the Commission staff.
For quite a while, I have viewed the SEC and independent fund directors as partners in the protection of America's 95 million mutual fund investors. On a fundamental level, we are both charged with the same responsibilities: overseeing fund activity, ensuring compliance with the federal securities laws, addressing conflicts between fund service providers and the funds they service, and promoting the interests of individual fund investors. The major difference in our missions is that the SEC performs these functions on an industry-wide basis, while you, independent fund directors, operate in the trenches, with a focused view on the individual funds you oversee. While neither the SEC nor independent fund directors can do our jobs alone, together we must represent a powerful force for the protection of fund investors. This challenge is now more critical than ever before.
II. Fund Directors Cannot Tolerate Breaches of Fiduciary Obligations
We have recently seen serious breaches of fiduciary obligations by those entrusted with the investments of millions of American investors. These gross violations of the law cannot be tolerated and Chairman Donaldson has made it clear that the Commission will move quickly and aggressively to hold the wrongdoers accountable. You have seen recent enforcement actions of the Commission in this regard, and more actions will follow. Working with other regulators, the Commission is sending a strong message that will resonate for years and years that those who violate their fiduciary obligations will pay a heavy price for such violations. If that is not enough, certainly the market is taking a heavy toll on those who have abused investor trust.
Many mutual fund firms and fund intermediaries, as encouraged by the Commission, are engaging in an examination of whether they have late trading and market timing issues. I hope that you as independent directors are likewise demanding these assessments and asking the tough questions about whether your service providers, including fund advisers, fund underwriters and intermediaries who sell and offer your funds, have problems in these or other areas. If issues surface, and if fund management is not taking appropriate actions to address these matters, I hope that you as independent directors are demanding swift and aggressive action.
As Chairman Donaldson emphasized last night, "you must wield your power appropriately to ensure that the interests of your fund investors are protected." You have the power to "clean house" if necessary. You do not need to wait for an SEC enforcement action or new regulation to demand change. You have the authority to require immediate remedial actions to address problems and to prevent the recurrence of these types of problems in the future. You must insist that your service providers are focused on your investors' best interests, first and above all else. And the ultimate injustice would occur if those directors who oversee funds caught up in the recent scandals allow management companies to pass the costs associated with their problems to fund shareholders. This cannot happen.
III. Directors Tool Box
The SEC has long recognized the critical role that independent directors play in the mutual fund regulatory framework. As Chairman Donaldson emphasized in his remarks, recent events highlight the importance of strengthening fund governance and the effectiveness of independent directors as steps to restore investor confidence in the mutual fund industry. Consequently, because of your vital position as "front line" watchdogs, we want to make sure you have the tools you need to best perform your duties. I would like to discuss some of these tools-and how you can use them to maximize your effectiveness. In your director's tool box, you must at least have a hammer, a flashlight and a drill-and I hope many of you don't need an instruction manual.
A. Independent Legal Counsel
The first tool I would like to discuss is the "drill" and that is the use of independent legal counsel. Independent legal counsel can assist directors in "drilling" down through the mounds of paper and other information you receive before each board meeting to reach the core issues that require particular director attention and evaluation.
In 2001, the Commission amended a series of exemptive rules to require, in essence, that any person who acts as counsel to a fund's independent directors be an independent legal counsel. The Commission's goal was to promote the concept that independent fund directors should receive unbiased, independent legal advice when performing their duties to protect the interests of fund shareholders -- from negotiating advisory contracts and overseeing fund fees, to policing conflicts of interests between the fund and affiliated parties. Thus, independent directors' legal counsel should not be influenced by conflicting representations of, or allegiances to, fund management.
The rules do not require that independent directors have an independent legal counsel, only that any counsel who represents them be independent. However, I believe that recent events dictate that all fund boards would be well advised to have independent legal counsel. I believe that independent directors can benefit greatly from the kind of guidance and insight that independent legal counsel can provide. As you are aware, mutual fund regulation is extremely complex. There are a myriad of rules and regulations, and some I dare say are very esoteric. Consequently, independent directors are well served by a legal expert who can help them "drill" through the various layers of regulatory requirements.
Independent directors can further benefit from an independent voice to drill through the regulatory requirements faced by directors at each board meeting and pinpoint key regulatory issues on which directors should focus. As "watch dogs" independent directors must understand what it is they must "watch." Independent counsel can be valuable in this regard. Independent counsel also can offer a perspective on an issue that might differ from management's and help independent directors best focus on issues as investors' representatives. Finally, independent legal counsel can keep directors up to date on the latest industry trends and regulatory issues. So if you do not have independent legal counsel, you should give it serious consideration.
Now let me turn to those of you who serve as legal counsel to fund directors. Last night, Chairman Donaldson indicated in his remarks that America's mutual funds do not need passive fund directors, but proactive fund directors who are continually challenging fund management, particularly in key high-risk areas, such as pricing, internal controls and compliance functions. Independent counsel can be helpful to fund directors in assisting them in asking the appropriate questions, and obtaining the necessary information and reports that facilitate proactive oversight on the part of fund directors. Independent counsel's central focus should be in assuring that the fund directors are fulfilling their fiduciary duties to fund investors by making informed decisions, and working as advocates for the interests of fund investors.
Independent counsel must work zealously to assist fund directors in making the appropriate inquiries and carrying out their responsibilities to fund investors. Zealously representing fund independent directors means that there may be times when counsel may have to ask the tough questions that the directors may be uncomfortable asking. In other words, you may have to be the thorn in the side of the management company. In private practice, unfortunately, I observed situations where some independent counsel was docile and passive and other situations where independent counsel was effectively doing the job by pressing fund management to provide necessary information to the fund directors so that they could fulfill their responsibilities. In one situation, counsel was later fired by the fund directors after management company personnel urged that the independent directors replace their counsel for being too aggressive in seeking information and the answers to key questions. This occurred under circumstances where directors must be extremely vigilant, when the management company was undergoing a change in control, and the directors needed to understand fully the implications of the change and what it would mean for fund investors. These directors did not have the backbone to tell the management company no, you are not going to tell us who our counsel should be. In other situations, I observed independent counsel, at the request of fund directors, take the lead in negotiating lower management fees to benefit fund investors. So, clearly, there is an important role that independent legal counsel can play in assisting fund directors.
B. Chief Compliance Officer
The newest tool available to fund directors is a "hammer," that is a chief compliance officer. As the individual who enforces a fund firm's compliance culture, the chief compliance officer must "hammer" home the importance of complying with policies, procedures and regulations and also "hammer" down on those persons who are not meeting their compliance obligations.
Last month, the Commission adopted new rules containing the chief compliance officer requirement and mandating that all funds, by October 5, 2004, designate a chief compliance officer who has been approved by the board, reports directly to the fund's board, can be removed only with the board's consent and is empowered with full responsibility to develop and enforce appropriate policies and procedures for the fund. The rule envisions the compliance officer position as someone of sufficient seniority and authority within the fund group to compel others to adhere to the fund's compliance policies and procedures.
In order to bolster the independence of a fund's chief compliance officer, a fund's board, including a majority of the independent directors, must approve the chief compliance officer's compensation, as well as any changes in compensation. In addition, the chief compliance officer will be required to meet in executive session with the independent directors at least once each year, outside the presence of fund management and the interested directors. This executive session will create an opportunity for the chief compliance officer and the independent directors to speak freely about any sensitive compliance issues of concern, including any reservations about the cooperativeness or compliance practices of fund management.
Of course, as independent directors, you should meet with the chief compliance officer as often as you deem necessary. I believe that these sorts of independent meetings can lead to more fulsome discussions and encourage constructive dialogue between a fund's independent directors and the person you have assigned with the all-important task of overseeing a fund's compliance functions. In addition, the chief compliance officer can become an important source of information for you, especially information that has not been "sanitized" by fund management and management's lawyers.
Recent events have highlighted that independent directors must no longer be kept in the dark about significant compliance lapses at fund complexes-and then be left looking uninvolved or out of touch when a compliance lapse becomes a huge issue. Consequently, I encourage you to make sure that the chief compliance officers at the fund groups you oversee are individuals of integrity and competence who will, most importantly, act as your eyes and ears on compliance matters and keep you informed regarding compliance issues.
In many ways, I believe that the chief compliance officer requirement may prove to be one of the most important and most meaningful investor protection requirements that the Commission has introduced into the fund regulatory framework in recent years. I strongly encourage you to take full advantage of this "hammer" and to identify and designate a chief compliance officer well before the October 2004 compliance date.
The compliance rule also is designed to ensure that funds and advisers have policies and procedures in place that will lessen the likelihood of securities law violations and that the adequacy of these procedures be reviewed at least annually. I urge you to make a significant commitment in working with your funds' service providers to ensure that your fund groups have in place the necessary controls and procedures to avoid the types of compliance failures that we have recently observed. This requirement should facilitate fund directors' oversight of the effectiveness of a fund's internal controls and procedures. Through the annual review process you should get a sense of procedures and controls that are working well and those that can be improved.
C. Fund Auditors
Of course year in and year out, another-possibly underutilized--tool available to fund directors is the fund's independent auditor. A fund's independent directors select the fund's independent auditor, and the auditor reports to the fund's board. Independent directors also typically meet in executive session with a fund's auditor and have access to the auditor's expertise throughout the year.
Fund auditors, I refer to as a flashlight, as they can illuminate weaknesses in controls and identify issues that could result in risk for the fund. Auditors provide expert insight and, importantly, independent insight on a variety of fund accounting and related issues, such as pricing and valuation issues. Thus, you should make sure that your executive sessions and other meetings with fund auditors are meaningful discussions and not perfunctory exercises.
As you may recall, last year the Commission issued a concept release on ways to increase involvement of the private sector in overseeing fund compliance. One of the methods the Commission suggested was expanding the role of a fund's independent auditor to include an examination of the fund's compliance controls. I believe this is an area worthy of further exploration, and I encourage you to engage in fulsome discussions with your funds' auditors about control procedures.
D. Proposal of Additional Tools for Fund Directors
As was announced by Chairman Donaldson, the Commission next week will consider a proposal regarding additional tools to assist independent directors and strengthen your ability to represent fund shareholders. These will include proposals to (1) require an independent chairman of a fund's board of directors, (2) increase the minimum percentage of independent directors under SEC rules from a majority to 75%, (3) provide independent directors with the authority to retain staff as they deem necessary and (4) require fund boards to perform an annual self-evaluation of their effectiveness, including consideration of the number of funds they oversee and the board's committee structure.
Taken together, these proposals reinforce the tenet that independent directors should "control" a fund's board. Independent directors should not be passive observers on a fund's board, but instead should be "calling the shots." With an independent board chairman and with independent directors representing at least 75% of a fund's board, independent directors will dominate the boardroom-by controlling both the board agenda and the board's votes.
By emphasizing the ability of fund directors to retain staff as they deem necessary, the Commission would be emphasizing the importance of relying on experts outside of a fund's management in certain circumstances to provide information to the board. A board can only be as effective as the quality of information it receives, and if a board is relying solely on a fund's adviser for the information it uses to make decisions on behalf of fund investors, the board may not be considering all the information it needs to make the best decisions on behalf of fund investors.
Board self-evaluation, if conducted thoroughly and thoughtfully, can also be an effective tool in identifying structural changes and processes that can enable a board to be a more vigilant overseer. Even though, at this stage, board self-evaluation is an initiative the Commission will be considering for proposal, at this time when many are questioning the effectiveness of independent directors, I would encourage all fund boards to begin conducting their own comprehensive evaluations. Boards should focus on whether they are organized to maximize their effectiveness, consider the number of fund boards on which individual board members sit, and also consider the nature and effectiveness of their board committee structures.
In conclusion, I believe that some of the new tools the Commission is making available or is considering making available to independent fund directors (such as a chief compliance officer who reports directly to the board, an independent chairman and a greater percentage of independent directors) coupled with better use of the tools currently available (such as truly independent legal counsel and independent fund auditors) will serve to bolster fund directors' authority and oversight abilities. Many of these tools are designed to decrease independent fund directors' reliance on fund management companies as a sole source of information and encourage fund directors to seek out where appropriate outside sources of information when examining fund fees, performance, accounting issues, compliance matters and conflicts of interest. I believe the new initiatives the Commission will consider next week are designed to empower independent directors to stand up on behalf of investors when necessary.
Fund investors, and of course the Commission, rely heavily on you to perform the duties of fund directors to the best of your abilities. We are working to provide you the tools and the support to fulfill this critical task. But you must do your part on behalf of investors to use the tools provided. Indeed, you have a self-interest in using these tools. You do not want to be accused of overlooking more than you oversee. You do not want negative publicity. Nor do you want to be investigated and caught up in a SEC enforcement action. And, most importantly, you do not want to let down your funds' investors. So you should have sufficient motivation to do your job as effectively as possible.
Finally, I would like to echo Chairman Donaldson's support for the work of the Mutual Fund Directors Forum. I also want to express my great appreciation to the Forum for answering Chairman Donaldson's call for the development of guidelines and best practices for mutual fund directors in certain key areas. I believe that fund directors, and most importantly, fund investors, will benefit greatly from the time, talent and energy that is being put into creating these best practices.
I would also like to thank the independent directors in the audience, who, by your presence, are displaying a commitment to stay involved, get up to speed on important issues, so that you can better protect the interests of fund investors. America's investors can be well served by men and women who are willing to continue their professional education to become as effective directors as possible.
Thank you for listening. I hope you enjoy the remainder of the conference.