SEC Speech: Remarks to the Mutual Fund Directors Education Council (N. S. Johnson)
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U.S. Securities and Exchange Commission

Speech by SEC Commissioner:
Remarks to the Mutual Fund Directors Education Council

by Commissioner Norman S. Johnson

U.S. Securities & Exchange Commission

Washington, D.C.
February 18, 2000

It is certainly an honor to be part of the inaugural conference of the Mutual Fund Directors Education Council. I should note that I speak today only for myself and not for the Commission or my fellow commissioners.

As an advisory member of the Council, I know how much effort and preparation has gone into making this conference a success. I want to thank the mutual fund directors in the audience for devoting your time in an effort to improve fund governance.

Few issues are as important in this era. The 77 million investors whose livelihoods are now tied to mutual funds rely upon your efforts and intelligence. You are the custodians of the interests of your shareholders. Responsibility and integrity are your watchwords.

Recently, the Commission and the mutual fund industry have been working to enhance the effectiveness of independent directors. The Investment Company Institute established an Advisory Group on Best Practices for Fund Directors, which recommended a number of "best practices." I hope that the boards on which you serve are giving serious consideration to implementation of them.

As we all know, however, the ICI best practices are only recommendations. Our experience with similar recommendations is that a group of underachievers may fail to hit – or come close to – the mark.

In yesterday's panel, Paul Roye and Bob Plaze discussed the Commission's recently proposed fund governance reforms, which attempt to set minimum standards. Briefly, the proposals would:

  • Require that independent directors constitute a simple majority or two-thirds super-majority of fund boards.

  • Require self-selection and self-nomination of independent directors.

  • Require that any counsel for independent directors be "independent legal counsel."

  • Require enhanced disclosure about the fund's board and certain conflicts of interest.

These rule proposals are now pending. Therefore, I look forward to reviewing the comments before taking a position on their advisability. However, there are certain best practices that I believe all boards should adopt regardless of whether these best practices are ultimately adopted in SEC rulemaking. Since we are here to discuss board composition issues, I will focus my attention in this area.

The first best practice would require fund boards to have a majority of independent directors. Such a board is better equipped to perform its responsibilities of monitoring potential conflicts of interests and protecting the fund and its shareholders. By virtue of its independence, and its ability to act without the approval of the investment adviser, such a board is better able to exert a strong and independent influence over fund management. This is particularly important in circumstances where the fund's interests conflict with those of the adviser.

Today most, but not all, mutual funds have boards with at least a simple majority of independent directors. A simple majority requirement would permit, under state law, the independent directors to control the "corporate machinery" – to elect officers of the fund, call meetings, solicit proxies, and take other actions without the consent of the adviser. I strongly advise boards without an independent majority to consider adopting this better practice.

At the mutual fund roundtable the Commission hosted last year, many participants believed that a fund board generally is more effective if independent directors represent a substantial majority of the board. Similarly, the ICI Advisory Group Report recently endorsed the "super-majority" concept. The Report concluded that a two-thirds majority of independent directors "will be more effective than a simple majority in enhancing the authority of independent directors." I hope that funds give serious consideration to this best practice regardless of whether the Commission ultimately requires a super-majority.

On a second point, I believe fund boards should have a mix of backgrounds and experience. This means that the boards of all funds should have corporate and financial expertise. For sector and international funds, I would recommend further expertise in whatever industry or region the fund invests in.

The exact mix of background and experience for each fund is very fact-specific. But there are some general, common-sense guidelines. It is important that the size of the board be manageable. Obviously it is important to have enough diverse views and backgrounds on a board to foster healthy debates on issues. However, adding members can cause potential conflicts to increase. As I'm sure you recognize, larger groups generally are also less efficient.

I also believe that the self-nomination process is an excellent best practice. Self-nomination is designed to prevent a fund's board from being "captured" by its management. Independent directors should seize the opportunity to "police" their board's balance. In addition to the usual conflicts analysis, the nominating committee should screen all candidates using factors such as the number of other boards the candidate serves on, management ties, and relevant business and regulatory experience.

Some have asked whether self-nomination completely shuts out management from the nomination process. My answer is "no." Management should be able to suggest candidates to the nominating committee. However, the final decision rests in the hands of independent directors.

One key role that independent directors must play is effective oversight through the Board's Audit Committee. The Audit Committee should be entirely composed of independent directors. Very generally, 3-5 members on the Committee seems to work best; although each board must make its own determination. The members should have broad business experience, and knowledge of the fund's operations, financing, and accounting. They must also be able to obtain information from management and other relevant sources. Members must have the time and energy to devote to their duties. Membership continuity is also desirable.

Finally, independent directors should periodically assess the effectiveness of their boards. General issues that directors should consider include: (1) whether the board meets often enough, (2) whether management supplies directors with necessary and timely information; (3) whether the independent directors should meet separately on occasion; and (4) whether the board's organizational structure is efficient and effective.

I hope that some of the best practices and proposals described today will enhance your ability to act as forceful advocates for investors. Independent directors and the Commission share a common goal of protecting investors. Mutual fund investors owe you a debt of gratitude for the daily commitment that you make to your independent watchdog role.

Thank you.