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U.S. Securities and Exchange Commission

Speech by SEC Staff:
Statement at the SEC Open Meeting

Paul F. Roye

Director, Division of Investment Management
U.S. Securities & Exchange Commission

Washington, D.C.

January 14, 2004

Thank you. Mr. Chairman.

This morning we recommend that you propose rules that will improve the way mutual funds are governed. The rules are designed to enhance the independence of fund boards of directors, and strengthen their hand when dealing with fund management. This is the next in a series of regulatory initiatives designed to address concerns regarding abuses in the mutual fund industry.

One of the most significant and enduring problems in the mutual fund industry and the one that animates many provisions of the Investment Company Act - is how to deal with conflicts between fund managers and the funds they advise. It is clear that these conflicts exist and can be substantial and ongoing. The 1940 Act deals with some of these conflicts - by prohibiting certain transactions, by engaging shareholders in some decisions, and by requiring disclosures to shareholders. But the securities laws heavily rely on boards of directors to police the fund managers' conflicts, and to serve as a check on fund management.

In some of the enforcement cases the Commission has considered recently, we cannot blame fund boards for the compliance lapses involving their funds. Fund managers actively concealed these compliance issues from the Board. But troubling questions persist as to why management controls appeared to have broken down at these firms, and how managers were able to successfully conceal these problems. What questions could have been asked that would have unraveled the frauds at an early stage? What steps could boards have taken that would have prevented the types of abuses we are seeing?

One possible answer lies in the tendency of fund boards to be dominated by the fund adviser. In some cases, there is a personality who looms large - often the CEO of the fund manager-to whom individuals including directors within the organization find it very difficult to say "no." Being a director in a mutual fund, however, can mean having to say "no" to the fund manager. It means having to turn down requests for fee increases that are not in the interest of fund investors. It means having to hold fund management's feet to the fire when there is bad performance; it means holding fund management accountable for compliance lapses. It means having to ask the tough, unpleasant questions at the board meeting, when there are incentives to be quiet and go along.

Management-dominated boards are less likely to be able to fulfill the important tasks assigned by the Act. Congress recognized this by requiring that at least 40% of the directors on fund boards be independent. You underscored the importance of an independent and effective board in 2001 when you required that a majority of fund directors be independent, that they be self-nominated, and that their counsel be free of significant conflicts that might affect counsel's judgment.

We believe that recent events suggest a need to revisit fund governance and address additional issues. The effectiveness of a fund board depends on the quality and vigilance of the directors and the governance practices followed by fund boards. While we cannot select the directors that serve on fund boards, and ensure that they all diligently carry out their responsibilities, the Commission has the ability to require improved governance practices. Our recommendations are based on a careful review of the suggestions of corporate governance experts, suggestions by fund directors themselves, and our own experience both counseling and regulating mutual funds. They reflect practices already in place in some, but not all, fund groups.

1. Expand the Number of Independent Directors.  First, we recommend you increase the number of independent directors on fund boards to 75%. Today, Commission rules require a majority. A 75% independent board means that the independent directors can dominate the process and we believe establishes a framework for decisions that are in the best interests of fund investors.

2. Independent Chairman.  Second, we recommend you require that the chairman of the fund board be an independent director. Today, the chairman is typically the CEO of the adviser. We believe that a fund board with an independent chairman and independent leadership is more likely to be an effective check on fund management. A fund board would, for example, be more effective when negotiating with the fund manager over significant matters such as the amount of the advisory fee, if it were not at the same time led by an executive of the adviser with whom it is negotiating.

3. Self Evaluation.  Third, we recommend that you require fund boards to perform self-evaluations each year. The self-evaluation process will give the directors an opportunity to consider their own performance. As you mentioned, this self-evaluation would have to include a consideration of the number of funds on whose boards the directors serve, and the effectiveness of the board's committee structure. We don't want to tell directors how many funds they should oversee. Rather, we want to make them think hard about whether their service on multiple boards permits them to fulfill their obligations to each fund. In addition, we want them to focus on the effectiveness of the board's current committee structure. In other words, we want them to ask themselves each year how they are doing, and what changes in the structure of the board might be necessary for them to do their job better.

4. Separate Meetings.  Fourth, we recommend you require that independent directors hold separate meetings without the presence of fund management. These meetings will give the independent directors and opportunity for frank and candid discussion about the fund's management.

5.Separate Staff.  Fifth, we recommend you require that fund boards give their directors the authority to hire their own staff to help them carry out their duties. Directors often must take action on matters where they may not have enough expertise themselves to analyze the issues. There may be times when the directors need help and we want to ensure that they have opportunities to obtain the assistance and information they need from those other than the management company.

6. Recordkeeping.  Our final recommendation is a change to the requirements about records that funds must maintain. The board of directors, including the independent directors, must approve the fund's advisory contract each year, including the level of fees that the adviser charges the fund. The Investment Company Act requires that directors request, and advisers provide, information relevant for the directors to scrutinize that contract. The Commission's examinations staff has encountered some problems in determining the nature and quality of the information used by the directors in carrying out this important duty, because our rules do not require that funds retain these materials. Requiring funds to retain these records will help our staff to determine whether directors have relied upon sufficient information to approve advisory contracts.

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We don't pretend that these recommendations alone will be a "silver bullet" that will prevent future scandals from occurring, or result in the large-scale reduction of advisory fees. We acknowledge that some of the funds involved in the current scandals would meet some of the governance requirements we recommend you propose. However, we believe that strengthening the fund governance framework, along with the other measures the Commission is taking to facilitate the detection and deterrence of abusive activity, market structure changes and full and fair disclosure are part of the solution to the problems that currently befall the mutual fund industry.

We do believe that the logic of our recommendations is compelling. If we are to have fund boards, the purpose of which is to serve as an independent "watchdog" for fund investors, then they had better be "independent" of fund management. We believe the steps we recommend will promote greater independence and strengthen fund boards. We believe this is part of a response that 95 million mutual fund investors are looking for the Commission to provide.

We would be pleased to answer any question you may have.



Modified: 01/14/2004