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U.S. Securities and Exchange Commission

Speech by SEC Commissioner:
The Independent Counsel Requirement of the Fund Governance Proposal

by Paul R. Carey

Commissioner, U.S. Securities & Exchange Commission

Fall Meeting of the ABA's Committee on Federal Regulation of Securities
Washington, D.C.

November 10, 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. Carey and do not necessarily reflect the views of the Commission, the Commissioners, or other members of the Commission's staff.

Good evening. I want to thank you for inviting me to speak to you this evening. I am glad to have the opportunity to meet so many Committee members. This group provides thoughtful commentary and analysis on the issues before the Commission. We value the views of this group and consider the role that you play to be very important to the Commissionís processes. To that end, I would like to speak tonight primarily about a rule proposal that this Committee did indeed comment upon: the role of independent directors of investment companies. As always, I note that the views I express are mine alone, and are not meant to reflect the views of the Commission or its staff.

About a year ago, the Commission issued proposed rules designed to enhance the effectiveness of independent directors and to improve an investorís ability to assess the independence of those directors. As you may recall, the Commissionís attention, as well as that of the industry and fund shareholders, became more focused on the role of independent directors in the wake of the Strougo, Navallier and Yacktman litigations. As you also may recall, the role of independent directors was discussed at the fund governance roundtable hosted by the Commission in February 2000. At that roundtable, the Commission posed a variety of questions to industry participants, independent directors and others, to elicit their views about the proper role of independent directors. Fund governance has also been the subject of many industry conferences and ABA meetings. We have your Task Force report, and I understand that tomorrow morning your investment companies committee will focus on these issues.

Based in part on what we learned from the litigations, the roundtable conferences and public comments, the Commission proposed to amend ten rules under the Ď40 Act that permit certain arrangements or transactions involving conflicts of interest, if the terms of the transactions are fully disclosed, and then approved, or overseen by independent directors. Since the Actís passage in 1940, obvious points of potential conflict, such as the setting of the terms of the management contract, were submitted to independent directors. And that role has grown to encompass, among other matters, monitoring of brokerage allocation under Section 28(e), approval of the use of fund assets for distribution under Section 12b-1, fair valuation of portfolio securities, and the 15(c) process.

More specifically, the proposal adds a number of conditions to the exemptive rules that a fund must meet to rely on the rules:

  • First, the independent directors constitute at least a majority of the board;
  • Second, the independent directors are selected and nominated by other independent directors; and
  • Third, and this third prong is key, the counsel of the independent directors, if any, is, in fact, independent, as well.

As you know, it is this third prong that has drawn the most fire.

Letís take a minute to review how this provision would work in practice. Independent directors are not required under this proposal to hire counsel, but if they do, the proposal would require that counsel be "independent." That means that the counsel could not, for the past two years, have served as counsel for the fundís adviser, principal underwriter or administrator or their control persons unless the independent directors find that counselís representation is, or was, so limited that, in their judgment, the counsel could nonetheless provide impartial, unbiased and objective legal advice to them. The basis for this determination would need to be documented in the boardís minutes. It is worth noting that the proposed amendment does not go so far as to prohibit a lawyer from acting as both fund counsel and independent director counsel.

The Commissionís goal here is very clear: to ensure that the independent directors receive independent legal advice in the more important conflict of interest situations, which come before fund boards at virtually every meeting. The structure of the fund industry -- where the adviser and funds are separate entities -- creates numerous opportunities for conflicts to arise. Moreover, we find ourselves today in a rapidly changing environment in terms of technology, products and delivery, and market choices and volatility. Conflict of interest situations have, accordingly, become more common and more complex. Increasingly, the industry, the Commission and fund shareholders are relying on independent directors to safeguard the interests of the fund shareholders -- to be the "independent check" on fund management, referred to by the Supreme Court in Burks v. Lasker -- to be the fund shareholdersí representatives in their fundís relationship with its investment adviser. Given this environment, independent counsel is a vital element in safeguarding the independence and integrity of the decision-making process of independent directors. Any independent director who serves on a fund board and understands the importance of his or her role should view independent counsel as a condition for serving as a director -- just as one would not serve on a board without D&O liability insurance.

As the first line of defense for fund shareholders, independent directors cannot risk reliance on legal advice that may be colored by conflicting loyalties. Incidentally, this also makes good sense for the management companies, since courts have recognized that directorsí decisions are entitled to greater deference when they are advised by independent counsel. The presence of independent counsel, for example, was given significant weight by the Second Circuit in Gartenberg in weighing the challenge to Merrill Lynchís management fees.

Letís step back a minute and examine in greater detail the role of independent directors and how a lawyer serving two masters -- the fund adviser and the independent directors -- may find it difficult to resolve possible conflicting loyalties. Independent directors often seek counselís advice, for example, during the 15(c) process, on the standards and considerations that apply to the setting of the management fee to be paid to the fundís adviser, and the level of 12b-1 fees to be paid by the fund and the allocation of fund brokerage commissions. Is it realistic to expect that the shared counsel, when engaged in dual representation of the adviser and the directors, will advise the independent directors that the adviserís compensation may be viewed as excessive by a court, except in the most egregious situations? It isnít difficult to envision other situations where a counsel to both the independent directors and the adviser or other fund management will have conflicting loyalties. To name a few, consider:

  • Directorsí consideration of managementís proposal to raise 12b-1 fee payments from fund assets to distributors for the sale of fund shares;
  • Effective review and monitoring of the adviserís soft dollar and brokerage allocation practices; and
  • Monitoring of the transactions between the fund and its adviser or other affiliates.

In these matters, independent directors often depend on their counselís advice. Yet, even with the best of intentions, counselís simultaneous representation of the adviser on these matters might well dampen his or her zealous representation of independent directors and the interests of fund shareholders. As we all know, there are numerous other situations where the interests of the adviser, and the fund and its shareholders may diverge. For example, interests may conflict:

  • Where a fundís audit committee receives the auditorís management letter and considers the adequacy or inadequacy of the adviserís internal controls -- particularly, if the shared counsel helped craft those internal controls for management; or
  • In the area of compliance oversight -- where inspections require changes in an adviserís procedures -- again, particularly if the shared counsel advised management with respect to those procedures.

Interests may also conflict:

  • if the adviser wants to change the fundís investment policies, merge funds or significantly reduce its professional staff;
  • if the adviser seeks the directorsí consent to a valuation method for illiquid securities; and
  • if the directorsí consent is sought in connection with a change of control of the adviser and consideration of a new advisory contract.

But, despite the appearance and fact of enhanced integrity that independent counsel would add to the role played by independent directors, we have heard considerable objection to this proposal. Opponents to this provision argue that:

  • Independent directors are sophisticated and experienced and certainly capable of choosing appropriate counsel, if the extent and nature of counselís conflicts are disclosed to them.
  • Selection of counsel is a personal and sensitive decision, and the Commission should not interfere with the independent directorsí choice.
  • Any ethical conflict of interest issues are matters more properly resolved by state bar authorities.
  • And, finally that there is no tangible evidence that shared counsel have behaved improperly when advising independent directors on the types of conflict situations outlined above.

Opponents of the proposal suggest that this an area better suited for a "best practices" approach rather than a hard and fast rule. To that end, the ICI has issued a best practices provision that is more stringent than our rule proposal. A Task Force formed by various members of your Committee, chaired by Diane Ambler, also prepared a Report to provide guidance to independent directors when selecting and using legal counsel. Opponents would prefer that the Commission trust that the shared counsel is adequately recognizing and disclosing the conflicts of interest to their clients, and that the independent directors are acting appropriately in these conflict situations.

The issue, as I see it, is not one of trust, or a failure to trust, that shared counsel and independent directors are attempting to resolve conflict situations in an appropriate manner. The critical question for me as a Commissioner charged with an investor protection mandate is whether we should be doing more to ensure that any counsel advising independent fund directors is, in fact, independent. Currently, mutual funds hold approximately 7.6 trillion dollars in assets, and half of all households in America own mutual fund shares. Buttressing the independence and effectiveness of independent directors seems particularly necessary in an environment where an unprecedented number of investors and dollars are invested in mutual funds. Clearly, I do not think that we need to wait for documented abuse to conclude that significant real or potential conflicts, with such clear impact on fund shareholdersí interests, should be left to "best practices" or the vagaries of state or local bar enforcement. I donít believe that it is appropriate for us to shift our investor protection mandate to state bar associations by holding them primarily responsible for uncovering and disciplining a lawyer who fails to adequately represent an adviser and directors for acting on both sides of an advisory contract negotiation, for example.

In this regard, our initiative here is consistent, from a policy stance, with our initiative in the area of auditor independence. In both areas, we must ask whether our investor protection mandate requires that we remove or limit the opportunity for certain relationships to color the outcome of issues of considerable importance to shareholders.

Given the recurring and serious nature of the conflicts with the adviserís interests, I am not convinced that mere disclosure of the conflict to the shared counselís clients adequately protects fund shareholders. For example, in the context of negotiation over an adviserís fee, I simply donít see how disclosure that the shared counsel was wearing two hats would result in the counsel providing the appropriate representation to both the adviser and the independent directors. More troubling, perhaps, is that we have heard from several sources that shared counsel are not always:

  • fully advising the independent directors of conflicts when they arise;
  • describing the effect their dual role may have in defending their director clients in litigation or challenge by our staff; and
  • clearly advising directors of alternatives that management may not care to explore.

In sum, I am persuaded that our investor protection mandate dictates that we help strengthen the very important role of independent directors. To that end, I think the Commissionís proposal goes a long way towards accomplishing that goal. While I have not yet seen what the staff is proposing that the Commission adopt as a final rule, and I expect some modifications suggested by the comments, I feel strongly that we should stay the course and adopt a rule dealing with independent counsel that enhances investor protection by providing independent directors with the legal help they need to remain effective in these more complex times.

I thank you for inviting me to share my views with you.