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U.S. Securities and Exchange Commission

Speech by SEC Staff:
What Does It Take To Be an Effective Independent Director of a Mutual Fund?

Keynote Address by

Paul Roye

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

ICI Workshop for New Fund Directors
Washington, D.C.

April 14, 2000

The Securities and Exchange Commission, as a matter of policy, disclaims responsibility for any private publication or statement by any of its employees. The views expressed herein are those of Mr. Roye and do not necessarily reflect the views of the Commission, the Commissioners, or other members of the Commission's staff.

I would like to thank the Investment Company Institute for the opportunity to speak with you this afternoon. I want to commend all of you for taking on the very weighty responsibility of serving as mutual fund independent directors and taking the time to participate in this extremely important educational effort. By the power vested in me by Chairman Levitt and the other Commissioners, I am here to officially deputize you as "SEC watchdogs" and swear you in officially as Mutual Fund Independent Directors. At the completion of this new fund directors workshop, you are invited over to the SEC headquarters to receive your official SEC Independent Director "dog tags." At this ceremony, Dawn-Marie Driscoll and John Haire will then show you the "secret" mutual fund independent director handshake. Seriously though, the Chairman and the other Commissioners have only authorized me to say that the views that I express today, are my views and do not necessarily represent the views of the Commission or my colleagues on the staff of the Commission.

I want to applaud this effort by the Investment Company Institute to introduce you to your important responsibilities as fund directors. I also want to commend the efforts of the experienced directors who are here today, particularly John Haire and Dawn Marie-Driscoll (who was recently named Fund Director of the Year by an industry publication), for taking the time to share their knowledge and experience, as fund directors, with you.

It is difficult to overstate the importance of the fund industry to our securities markets and to the financial futures of millions of investors. The fund industry has become the principal trustee of the nation's savings, with 83 million investors having invested their hard earned dollars in mutual funds. Open and closed-end funds today own nearly 17% of the value of all equity securities trading in the United States more than any other type of institutional investor. Clearly the growth of the industry to almost $7 trillion has not only been beneficial for the mutual fund industry, it also has been beneficial for the U.S. economy and fund investors. While the longest bull market in history has contributed to the success of the industry, it should also be recognized that this success has been achieved because of the confidence that investors have in the mutual fund industry.

Similarly, it is impossible to overstate the importance of effective independent directors to the future health of the fund industry. Chairman Levitt has emphasized that you are on the front line for investors. You are the principal guardians of investors' trust in the industry. You are there to see to it that mutual funds earn acceptable returns, that their fees are reasonable, that fund assets are safe and that investors receive the reliable services promised. Mutual fund investors deserve more than spectators; they deserve – and the industry has thrived under – active, engaged and strong-willed directors who stand up for investor interests before all else.

I know that many of you have also served on the boards of public companies. While your experience on these boards will no doubt assist you in the discharge of your fiduciary duties on mutual fund boards, there are several important distinctions that make your new roles uniquely challenging. The Investment Company Act and our regulations impose specific responsibilities on fund directors. Congress formulated the role of the mutual fund board of directors in light of the external management structure typical of investment companies. Although a fund's investment adviser and shareholders have common interests in many areas, there are conflicts of interest and potential for abuse inherent in this organizational structure. Under the regulatory framework, you are responsible for monitoring conflicts and representing the interest of shareholders. The 1940 Act embodies a pervasive regulatory scheme that contemplates an important and vigorous role for fund independent directors, in addition to the traditional responsibilities imposed on directors by state law. Therefore, you need an understanding of the relevant provisions of the Investment Company Act and you must be appropriately informed of the scope and nature of your duties and responsibilities. Undoubtedly this workshop will contribute to an understanding of these responsibilities.

You have heard and will continue to hear a great deal about your responsibilities as independent directors. But how does one become a good independent director? I would like to spend some time this afternoon discussing, in my view, what it takes to be an effective independent director, give you some examples of situations in which directors have failed to fulfill their responsibilities to fund shareholders and finally discuss some of the Commission's initiatives that will hopefully have a positive impact on your ability to discharge your duties.

What Does It Take To Be an Effective Independent Director?

Prior to accepting the position as Director of the Division of Investment Management, I practiced law for sixteen years in a major law firm, working with a variety of mutual fund clients. This afforded me the opportunity to observe a number of mutual fund independent directors, some good and some not so good. I would like to outline for you what I think are some keys to being an effective mutual fund director. For purposes of this discussion, I will assume that all of you meet the statutory definition of independent director and that you were selected because of your integrity, intelligence, good judgment and common sense. You clearly need these attributes in order to be a good independent director. But let me outline ten practical suggestions on how to be an effective independent mutual fund director.

1. Understand Your Responsibilities

By attending this conference, you have embraced my first suggestion, which is to understand your responsibilities as a mutual fund director. As I indicated previously, you have responsibilities under the federal securities laws, as well as duties of loyalty and care under state law. The Investment Company Act imposes on fund directors a number of specific duties and obligations that are not imposed on directors of other public companies. Moreover, fund directors have important responsibilities under the Securities Act of 1933 and the Securities Exchange Act of 1934. For example, under Section 11 of the Securities Act, as signers of a Fund's registration statement, you are liable for any untrue statement of a material fact contained in the registration statement, as well as material omissions in the registration statement. Therefore, it is important that you appreciate your responsibilities under these laws. I would suggest you spend time reading the ICI's "Guide for Investment Company Directors," as well as the "Fund Directors Guidebook," published by the American Bar Association, both of which review in detail your responsibilities as fund directors.

2. Learn the Mutual Fund Business

Next, Board members who do not have a background in the industry must be willing to invest some time learning the fundamentals. How do mutual funds operate? What are the roles of the various service providers to the funds (i.e., the roles of the investment adviser, fund administrator, distributor, custodian, transfer agent, accountants and lawyers)? How are the funds sold? In what distribution channels? Who are your competitors? How is money made in the fund business? With an understanding of the mutual fund business, you will be able to make better oversight judgments and be better equipped to ask insightful questions as you carry out your responsibilities. You also need to stay abreast of industry trends and regulatory developments, as they will undoubtedly affect your fund's operations.

3. Recognize Your Limitations

Next, as Dirty Harry so succinctly stated: "A man's got to know his limitations." You are not and should not try to be a full-time, day-to-day manager of the fund's operations. The fund's investment adviser is paid to do that. You are responsible for oversight. You are there to act as a control and check on fund management. You cannot micro-manage the fund and also focus on your broad oversight responsibilities. You are not and cannot be the fund's auditor or the fund's lawyer. You are entitled to rely on reports and opinions by the fund's officers and the investment adviser so long as you reasonably believe that they are reliable and competent with respect to the matters at issue. You can also rely upon legal counsel, outside auditors and other experts as to matters you reasonably believe to be within their professional expertise. You must use and rely on these service providers wisely.

4. Focus on the Important Issues

While fund directors cannot ignore any of their statutory and regulatory responsibilities, some responsibilities are clearly more important than others. Your workshop today focuses on three of the more important areas of director responsibilities, the investment advisory contract renewal process, which includes performance evaluation, fund distribution arrangements and board oversight of the portfolio management process. Focus on these areas, leads to focus on areas that have significant impact on fund investors, such as fee levels, fund performance and the management of the fund in accordance with the parameters set forth in the fund's offering documents. Some perspective on what is important and what is less important is useful.

5. Pay Proper Attention to Compliance/Internal Controls/Risks

Directors should have an understanding of the manner in which the fund's compliance program is structured and the nature of internal controls. This understanding is gained through regular reports and meetings with compliance personnel to discuss procedures and deficiencies. Directors should also discuss and review the adequacy of internal controls and procedures with the fund's independent accountants. You also need to understand the operational risks that arise in mutual fund operations, such as those arising from portfolio management, custody, pricing and technology. Breakdowns in compliance and internal controls can lead to major problems for the fund which can undoubtedly complicate your life as an independent director.

6. Insist on Quality Information

The quality of information provided to you by fund management significantly impacts your ability to perform your role effectively. Information submitted to you should be concise, well-organized and designed to inform. The information should be sufficiently complete to form a basis and complete record, for your decision-making. Memoranda, reports and other information should be provided sufficiently in advance of the meeting to provide time for thoughtful reflection and meaningful consideration by the directors. This is important, since if your decisions are attacked in litigation you will want the benefit of the business judgment rule. In reviewing an independent director's conduct, a court will not substitute its judgment for that of the director, provided that the director acted in good faith, rationally believed the action was in the best interest of the fund, and the director was reasonably informed. Thus, quality of information provided you is important, if you want the benefit of the business judgment rule.

7. Be Prepared

My next tip is that you have to be prepared for each meeting. I noted that you received the materials for this workshop in advance. If you did not review the materials prior to coming today, I hope you do not prepare for your board meetings in similar fashion. It is essential that you come to the board meetings having read the board materials. You should be in a position to discuss the matters on the agenda for the meeting, not to be briefed on the issues during the meeting. Many of the decisions you will be asked to make will require thoughtful deliberation. Being diligent in reviewing the information provided you and making appropriate inquiries as required, are consistent with your duty of care owed the fund. You must do your homework.

8. Commitment

Next, you have to have a commitment to being a good fund director. The duty of care requires you to devote the appropriate effort and energy to your duties. Service on a mutual fund board involves a significant time commitment. You must devote sufficient time and attention to fund matters in order to prepare for, attend, and participate in meetings of the board and board committees. You need to attend board meetings in person, not via teleconferencing. Your attendance record should be near perfect, except for emergencies. You also must be prepared to devote more time on fund matters, including participating in special board meetings, if the fund should have a crisis. If you are over-committed and cannot devote the time necessary to fulfill your responsibilities, you shouldn't be a fund director.

9. Have a Stake in the Enterprise

As a director, you should own shares of funds in the complex. The best way to understand the needs of your fund shareholders is to be one. This also affords you a firsthand look at the fund's level of service. You then see all the mailings and communications with fund shareholders and can make judgments about what is effective and what is not. If your fiduciary obligations aren't sufficient motivation, perhaps that fact that your money is on the line will motivate you to be vigorous in monitoring fund management and overseeing fund operations.

10. Independence

Finally, and perhaps most importantly, you need to be independent. Of course legal independence does not equate with real independence. Independence in my view is how you analyze and approach the issues before you. Is your central consideration what's in the shareholder's best interest? If so, you are functioning independently. While you need not be antagonistic toward management of the fund, you need to recognize that management's interests aren't always aligned with the shareholders of the fund and sometimes constructive skepticism is called for. The regulatory framework and the nature of the mutual fund business, creates a healthy tension between a fund's management and the independent directors. Sometimes it is necessary to probe and challenge to identify potential areas of concern before they become significant problems. In a new book, written as a resource tool for independent fund directors, entitled "The Uneasy Chaperone", James Storey and Thomas Clyde, state that being an independent director is a little like being a chaperone at a party, the chaperone should monitor and step in when necessary, but should never actively join in the merrymaking.

Hopefully these ten suggestions will assist you as you seek to fulfill your obligations as an independent director.

Directors' Liability

This exercise is not just philosophical because when a problematic situation comes to the attention of the SEC staff, such as a valuation problem or inappropriate investments, we are likely to question the extent of the independent directors' inquiries and deliberations regarding the matter. Unfortunately, our Division of Enforcement occasionally must bring actions against fund directors. In the words of Chairman Levitt, "There are, unfortunately, some situations in which fund boards overlook more than they oversee." As an aside, Enforcement is loath to sue the funds themselves, as that ultimately harms shareholders, the potential victims in any action. Specifically, Enforcement is most likely to sue a fund director when he or she has violated a clear duty owed to fund shareholders under federal law.

As discussed earlier, director's have express duties to shareholders under the Investment Company Act. For example, Section 2(a)(41)(b) requires the board to value "in good faith" those securities in the fund's portfolio for which market quotations are not readily available. Rule 12b-1 under the Act requires the board of directors annually to approve distribution fees for the fund's shares. Directors also must annually approve the fund's contract with its investment adviser. Finally, Section 36(a) of the Act authorizes the SEC to bring an action against any director who, through personal misconduct, breaches his or her fiduciary duty.

Additionally, a director can be held liable for misleading statements made by the fund. Directors have been held liable for misleading statements directly or as aiders and abettors of a violation committed by the investment adviser to the fund.

As an example of the type of liability a director can face, I'd like to briefly discuss a decision that was handed down by an SEC administrative law judge just last month against directors of a mutual fund, the fund's adviser and the adviser's founder. The judge found that the adviser illegally distributed shares of hot IPOs to directors of the funds without disclosure to the other directors, or shareholders of the funds, thereby creating a conflict of interest and a breach of fiduciary duty.

Fund directors should take particular note of the fact that the judge found two directors who received the IPO shares in violation of the law, in breach of their fiduciary obligations, including their duties of loyalty. Specifically, because the directors knowingly accepted hot IPO allocations without disclosing that fact to the fund and its shareholders, the directors put their personal interests ahead of the best interests of the fund and its shareholders. The directors were suspended from association with any investment company for 30 days and, in addition to having to pay back the gains they realized by flipping the IPOs, were ordered to pay fines of $25,000 and $10,000. Thus, there can be consequences in failing to seriously discharge your responsibilities or breaching your fiduciary duties to fund shareholders.

The Commission's Corporate Governance Proposal

Now, I would like to discuss, one of the more significant initiatives we have pending at the SEC, a comprehensive package of proposals designed principally to enhance your effectiveness as independent directors. As the financial services industry undergoes consolidation on a global scale, and wrestles with the issues brought about by technology and competition, the SEC will be called upon both to provide the flexibility needed to accommodate change, as well as to ensure investor protection. The Commission will have to rely, in no small part, on independent fund directors. We believe our governance proposals will offer you greater power to act independently and in the best interests of shareholders. We have received many thoughtful comments on this initiative that will enable us to improve upon the proposed rules.

Majority of Independent Directors

A major component of that proposal is a requirement that independent directors constitute either a simple majority or a two-thirds super-majority of the boards of funds that rely on any of ten commonly used exemptive rules (including rule 12b-1 and the rules that permit funds to engage in affiliated transactions). I believe that the dynamics of a board's decision-making process will be improved with at least a majority independent board and that such a board is better able to exert a strong and independent influence over fund management and oversee areas where the fund's and shareholders' interests might diverge from the interests of the adviser.

Self-Selection and Self-Nomination

A second proposal concerns the self-selection and self-nomination of independent directors. I believe that the self-selection and self-nomination of independent directors works to create a greater sense of autonomy from management on the part of independent board members. Directors who are selected and nominated by other directors are unlikely to feel beholden to fund management for their positions and therefore are free to speak their minds, question management and represent investors as their sole concern. Through the proposed self-nomination process, directors can give consideration to the skills and backgrounds of candidates for independent director positions so as to compliment the skills and backgrounds of existing board members.

While the purpose of this proposal is to prevent a fund's board from being "captured" by its management, I believe that management should be able to suggest candidates to the nominating committee. This would strike an appropriate balance because management may know of some great candidates for consideration by the independent directors. Of course the nominating committee should reject these suggestions if its members question the true independence of the candidates.

Independent Legal Counsel

Another of the Commission's proposals is that any person who acts as counsel to a fund's independent directors be an "independent legal counsel." Funds are subject to a complex regulatory scheme, which includes federal statutory law, SEC rules and regulations and state corporate law. Given this complexity, and the inherent conflicts of interest between a fund and its management, an independent director is well served by the assistance of a legal counsel who is truly independent of fund management. The guidance of independent legal counsel is a factor often looked upon favorably by courts and may help to shield directors, as well as fund management, from liability.

Many independent directors, however, do not have the assistance of a truly independent legal counsel. They rely on fund management to provide them with information, and then they rely on legal advice of counsel who also represents the fund's adviser. There is no independent filter. I believe that independent directors will feel more secure in their actions if they have their own counsel whose advice is not influenced by a relationship with fund management.

Many commenters on the proposal believe strongly that the proposal regarding independent counsel for directors was too paternalistic or that our definition of independent counsel was too rigid. However, we believe that encouraging the use of truly independent counsel by independent directors is one of the strongest pieces of our proposal. We are encouraged by the formation by the American Bar Association of a task force to provide guidance to independent directors of funds regarding choosing and retaining legal counsel, as well as to provide guidance to counsel regarding their professional responsibilities when representing independent directors. Their recommendations should be helpful as we work through this issue in connection with adopting a final rule.

Independent Audit Committees

Independent Directors can play an effective oversight role though the Board's Audit Committee. In many fund complexes, independent audit committees play an important role in assuring the integrity of financial statements and the maintenance of an internal control system. Our proposal seeks to enhance director independence and effectiveness by encouraging the development of fund audit committees composed entirely of independent directors.

"Insured versus Insured" Exclusions

Our proposals also would prohibit joint fund D&O/E&O insurance policies from containing "insured versus insured" exclusions. These exclusions, which were designed to prevent collusive activity among insurers, potentially could exclude claims made by independent directors if their fund's adviser sues them. Such exclusions could threaten the financial security of independent directors if they ever become involved in a conflict with an adviser or other co-insured. The presence of these exclusions also could inhibit directors from challenging a fund adviser if they know their personal assets could be at stake. When this issue surfaced in connection with disputes between fund directors and management, ICI Mutual Insurance Company responded quickly to amend its insurance policies to provide coverage to directors in the case of disputes with a fund's adviser.

Staff Interpretations

In addition to these rule proposals, the Commission's independent directors initiative includes staff interpretive positions designed to enhance the position of independent directors.

Some persons have questioned whether fund directors have the authority to use fund assets to participate in a proxy fight with a fund's adviser. On a broader level, some have questioned whether fund directors who take an action on behalf of the fund that somehow also benefits the directors may be engaging in a prohibited "joint transaction" under the 1940 Act. The Commission's initiative contains a staff interpretation clarifying that actions taken by fund directors that are within the scope of their duties as directors, do not constitute prohibited "joint transactions." The staff interpretation also addresses when a fund may pay an advance of legal fees to its directors in light of the 1940 Act's limits on indemnification of legal fees. These interpretations, along with the elimination of "insured versus insured" exclusions in joint D&O/E&O policies, hopefully will ease any concerns regarding your ability to act in shareholders' best interests without undue fear of personal liability.

The staff also has provided guidance concerning when and how mutual funds may compensate directors with fund shares. Along these lines, we believe that the relationship between fund shareholders and fund directors can be strengthened when their financial interests are aligned, i.e., when fund directors own shares in the funds on whose boards they serve. A director's willingness to invest in the funds for which the director is responsible is a vote of confidence in those funds by that director. On the other hand, lack of investment by fund directors may be a cautionary sign for fund investors.

Reducing Burdens on Directors

We do not expect directors to micro-manage funds, and we have taken several actions designed to reduce burdens on directors. In many instances, various functions and responsibilities can be delegated to fund advisers. We have taken recent actions related to fair value pricing, the monitoring of repurchase agreement transactions and foreign custody arrangements providing for delegation to reduce burdens on fund directors. We will continue to look for ways to reduce director involvement in routine, ministerial matters.

Directors' Self-Evaluation

But while the Commission can, and has, undertaken to significantly strengthen the framework of corporate governance, directors need to periodically assess the effectiveness of the boards they serve on. You should give serious consideration to adopting the recommendations in the Report of the Advisory Group on Best Practices for Fund Directors, established by the ICI. Your board should also periodically engage in self-evaluation. Your self-evaluation should focus on both substantive and operational issues. General issues that directors should assess include: (1) whether the board meets often enough, (2) whether the independent directors should meet separately on occasion, and (3) whether management supplies directors with the necessary and the right information in a timely manner, and (4) whether the board's organizational structure is efficient and effective.


I hope my suggestions on how to be an effective independent director will stimulate thought on your part. I also hope that you agree with me that the proposals and interpretations we have discussed here this afternoon will fortify your stature as independent directors and enhance your ability to act as forceful advocates for investors. You are our partners in the protection of investor interests and it is to you that mutual fund investors owe a debt of gratitude for the daily commitment that you make to your independent watchdog role. You deserve the SEC's support and assistance. And we hope that our proposals will enhance your authority and strengthen your position as we pursue our common goal of protecting investors.

But for all our efforts at the SEC, we cannot legislate independence. As Chairman Levitt has often said, director independence is more a state of mind than a legal status. I close with simply the following, as you carry out your day-to-day responsibilities as independent directors, be guided by the fundamental principal that you are a fiduciary, and with respect to every issue before you, be guided by what is in the best interest of investors.

Thank you.