Speech by SEC Staff:
"From Roundtable to Reform: Thoughts on How to Improve Fund Governance."
by Paul F. Roye
Director, Division of Investment Management,
U.S. Securities and Exchange Commission
Before the Practising Law Institute
The `40 Act Institute
New York, NY
April 22, 1999
Thank you. Good morning. Iím very pleased to be here. If youíve attended conferences like this one for as many years as I have, Iím sure youíve noticed that you can often tell which issue is currently under the Commissionís microscope by where it appears on the program. True to form, if you take a look at todayís program, youíll see that panel number one is on fund governance.
Fund governance, and the effectiveness of independent directors in protecting the interests of fund shareholders, have received a great deal of attention recently in the press, in the courts, and at the Commission. Stories have been published criticizing mutual fund directors and the amounts that some independent directors are paid. Lawsuits have been filed challenging the independence of directors, based on the number of boards on which they serve, and the compensation they receive. And the Commission has undertaken a broad initiative to determine what problems independent directors are encountering, and how their effectiveness can be enhanced.
As you know, in February the Commission hosted a roundtable on the role of independent investment company directors. We brought together independent directors, fund executives, fund counsel, investor advocates, and academics. Our goal was to assess the issues facing independent directors today, and to try to reach a consensus on ways to improve investment company governance.
The issue of enhancing the effectiveness of independent directors can be summarized in three questions:
- How can we more closely align independent directorsí and shareholdersí interests?
- What additional authority and protections do independent directors need to better fulfill their responsibilities?
- And what steps are necessary to ensure that independent directors have unbiased information on which to base their decisions?
Last month in Palm Desert, Chairman Levitt announced some of our preliminary findings. He outlined four broad proposals as part of an initiative that we believe will improve the effectiveness of independent directors. First, fund boards should have a majority of independent directors. Second, independent directors should be self-nominating. Third, outside counsel for directors should be independent from management. And, fourth, fund shareholders should have more specific information on which to judge the independence of their funds' directors. This morning Iíd like to talk about these proposals in a little more detail and let you know what other reforms weíre considering.
At the roundtable, there seemed to be a consensus that funds should have a majority of independent directors. Many of the independent directors who participated in the roundtable currently serve on boards where they are in the majority, so this result didnít really surprise me. I think that majority independent boards can have a positive effect on fund governance, improve the dynamics of the decision-making process, and thereby make management more responsive to the concerns of directors generally.
The idea of a majority independent board is not new. Itís one of those ideas that resurfaces every few years, and that seems to be a good idea at the time, but that has never been implemented. You can find references to it in the original draft of the bill that became the 1940 Act, in the Wharton Report from the 60ís, and most recently, in the staffís 1992 study. I think now is the time to finally implement this reform. True, many funds already have majority independent boards -- but some funds still do not. And I think that shareholders of all funds should receive the benefits that a majority independent board can provide.
I think that independent directors will be in a better position to look out for the interests of shareholders when they are in the majority. In fact, not only will majority independent boards allow directors to be more effective generally, it will also give them additional specific powers that they donít currently possess. For example, some have suggested that independent directors should have the power to terminate advisory contracts on their own. As you know, the Investment Company Act currently vests the power to terminate contracts in the board as a whole. As a practical matter, if independent directors were a majority on all fund boards, they should be able to terminate advisory contracts by themselves.
The second proposal made by the Chairman was that all independent directors should be self-nominating -- that is, the selection and nomination of new independent directors should be left to a fundís current independent directors. At the roundtable, the panel that I moderated had several independent directors who currently serve on boards of funds that have 12b-1 plans, and that consequently have self-nominating independent directors. There was a consensus on the panel that all fund shareholders could benefit from having self-nominating independent directors. I think that over time, as a fundís original independent directors leave and are replaced by new independent directors who donít have prior relationships with management, self-nomination can have a positive effect on a boardís independence.
Thatís not to say that management shouldnít be involved at all in selecting independent directors. I think management can provide valuable assistance to the board in finding possible candidates. But the ultimate decision on nominees should be made exclusively by the independent directors.
So how do we implement these first two reforms? There are several possibilities. The Commission has broad exemptive authority over many activities that are prohibited under the Investment Company Act. Traditionally, the Commission has adopted exemptive rules only when they are consistent with the protection of investors and the policies and purposes of the Act -- and when the conditions provide protections that are comparable to those provided under the Act.
Often, one of those conditions has been approval by the independent directors. There are a number of exemptive rules that allow funds to take actions that would otherwise be prohibited under the Act, if those actions are approved by the independent directors of the funds . For example, Rule 12b-1, and a number of rules under Section 17 all give the independent directors an important oversight role under circumstances involving conflicts of interest. Indeed, one of the most important roles of independent fund directors is to monitor conflicts of interest.
If you were to look at all of the rules under which independent directors have these types of duties, you would see that probably all funds rely on one or more of these rules at some point or another. One alternative we might consider would be to amend these rules to require that funds relying on them have a majority independent board and self-nominating independent directors. In theory, if we did that, these reforms would not be mandatory, because they would apply only when a fund relied on a rule. But in practice, most funds would find it necessary to comply.
I think that one of the collateral benefits of our independent directors initiative may be the liberalization of some of our positions in other areas. If we are successful in enhancing the effectiveness of independent directors, it may be possible for the Commission to delegate more authority to directors, giving the industry even more flexibility to take actions without first coming to the Commission for approval.
The third proposal raised by the Chairman was that outside counsel for independent directors should be independent from management. I know that itís fairly common for counsel to an investment adviser to provide legal advice to a fundís board of directors -- or for counsel to the funds to also provide advice to management. This issue has traditionally been dealt with through disclosure by counsel of the potential for conflicts and consent by clients to multiple representations. Indeed, in situations where there are clear conflicts of interest, such as in the case of an error resulting in losses to the fund or a change in control situation, the directors are often urged to retain special counsel. However, our goal in encouraging independent directors to have counsel that does not also represent management would be to ensure that the hard questions get asked and that the directors receive truly disinterested advice when carrying out their fiduciary duties.
Similar concerns may be raised if a fundís independent auditors also provide accounting or consulting services to the adviser. Can auditors retain their independent status if they are also working for management? Similar questions have been raised recently in the non-fund context about the multiple roles of some auditors. These questions may be better addressed by the professional accounting organizations that deal with issues of auditor independence -- rather than by the Commission -- but I think these questions are certainly worth asking.
These two issues are really part of a much bigger question that weíre looking at -- are directors getting the information they need to do their jobs effectively? Surely if the experts providing advice to directors are conflicted, the directors might not get the clear and objective guidance they need to fulfill their duties to shareholders. But beyond the question of conflicts, we want to make sure that directors are getting enough information to do their jobs.
As you know, most funds have no employees and the directorsí information flow is from the investment adviser; independent counsel can ensure that the directors have the information they need to make informed business judgments. Indeed, the advice of independent counsel can be of great benefit to both the directors as well as fund management in defending challenges to board actions. Moreover, I donít need to remind you that investment company directors have numerous responsibilities under the Investment Company Act. Independent counsel can guide the directors through this pervasive regulatory scheme.
One example of when the information provided to directors is critical, is the annual review of the fundís advisory contract. Are directors receiving sufficient information to make their findings? From what Iíve seen, I think that the answer generally is yes. Most funds and their counsel do a good job preparing for their annual review of the advisory contract. But I must tell you that there are exceptions. The staff has in fact come across situations where both the quantity and the quality of the materials provided to the directors has been questionable. As a result, you can bet that weíll be looking at these materials carefully. The Chairman has asked our inspections staff to pay specific attention to advisory contract and distribution plan renewals during their examinations.
The last proposal outlined by the Chairman is to give shareholders more information about directors, so that they can judge the independence of fund directors for themselves. Shareholders have the right to know whether one of their directors, while technically independent, has a prior or ongoing relationship with management.
Shareholders should also have the right to know whether their interests are in line with the directors, and whether their directors own shares in the funds they oversee. Currently, funds are only required to disclose in their registration statements the fund holdings of their directors and officers as a group. And if those aggregate holdings are less than one percent of the fund, they are required to disclose only that fact. I question whether disclosure like that is very meaningful to shareholders.
I also question current disclosure requirements about the number of funds that a director oversees. As you know, some recent lawsuits have alleged that simply overseeing many funds can compromise a directorís independence. Most courts so far have said that it doesnít. But I think investors should at least be able to find out the number of portfolios under a directorís supervision, and the length of time the director has been there. Currently, funds only disclose the number of registered investment companies from which a director receives compensation, not the number of portfolios the director oversees. There can be a very big difference.
Now, you may rightfully ask how many investors really want more information on fund directors? Granted, maybe not many. But regulators are fond of quoting Justice Brandeisís line about sunlight being the best disinfectant. That may be the case here too. I think that additional disclosure about directors may have the effect of discouraging certain relationships or activities which raise questions about a directorís effectiveness.
In calling for additional disclosure, I assure you that Iím not about to return to the bad old days of "disclosure creep" in fund prospectuses. I recognize that while this information is important -- and should be made available to shareholders -- it may not be the kind of information that all shareholders need in order to make an investment decision. If we go this route, weíll have to consider whether the SAI should be revised, or whether some other disclosure method is more appropriate.
In addition to the four broad proposals mentioned by the Chairman, I think there are some other ways that we can enhance the effectiveness of independent directors. For one thing, the Commission could issue guidance on the circumstances under which it might exercise its authority to treat a director as an interested person. As you know, the Commission has the authority to issue an order finding a director to be an interested person, due to a business or professional relationship with the fund or its adviser during the past two years. The Commission, however, has never issued an order under this Section of 2(a)(19), and it may be helpful to provide guidance on the types of relationships that might cause the Commission to do so. I also think that if we require new disclosure about directorsí relationships with management -- as I previously mentioned -- that information may help the Commission to more readily determine when itís appropriate to issue such an order.
We are also considering amending the rules under Section 31(a) of the Act to require that funds keep records that reflect the basis for initially determining and periodically confirming that independent directors are not interested persons under the Act. Of course, the inspections staff would pay special attention to these records.
I also think the staff could assist directors by issuing some interpretive guidance. There are several issues which have recently come to our attention that could benefit from some clarification. For example, certain persons have questioned whether fund directors have the authority to use fund assets to participate in a proxy fight. Last fall during a dispute between management and independent directors, management alleged that the independent directorsí use of fund assets to pay for the fundís proxy expenses somehow constituted a "joint transaction" under Rule 17d-1. At the time, the staff informally questioned this assertion. It may be helpful to clarify the analysis behind our position.
I also think the staff should clarify and revise the standards for determining when a fund may indemnify or advance legal fees to an independent director. The current standards under Section 17(h) of the Act date back to a 1980 release. Itís come to our attention that these standards may not work in practice as well as they could. We clarified the standard somewhat through an interpretive letter last year, but it may be time to revisit this issue generally.
Another issue that has caused a good deal of concern at the Commission is the existence of joint liability insurance policies for directors and fund management that exclude coverage for claims brought by co-insureds. What this means is that if management and directors have a joint liability policy and management sues the directors, the directors will not be covered. Certainly, independent directors who find themselves in litigation with management canít be effective representatives of shareholders if theyíre worried about losing their homes.
As you may have heard, shortly after the Chairman spoke about this issue publicly, ICI Mutual -- which insures much of the industry -- announced that it was modifying its co-insured exclusion to address this problem. We were very pleased by this, and I want to commend ICI Mutual for its swift response. Although ICI Mutual covers a very large part of the industry, we are still concerned about this issue and hope that the other insurers follow its lead. It may still be necessary to make amendments under Rule 17d-1 which permits joint liability policies.
As youíve listened to me talk about these proposals this morning, Iím sure that some of you may be skeptical. Some of you may be thinking that these proposals arenít necessary, or wonít accomplish much. If you feel that way, I imagine that it may be because, in your practice, you havenít encountered the types of problems that these reforms are meant to address. Most funds, thankfully, donít experience open conflicts between management and their boards. Thatís good. And if youíre counsel to funds where the independent directors havenít experienced any difficulties, you should consider yourself lucky.
But I must tell you, I think there are independent directors out there right now who have concerns, and who would welcome these reforms. Since our roundtable, we have received letters from both independent directors and industry insiders, encouraging us to move forward with these proposals -- and suggesting a few ideas of their own.
There are independent directors out there who take their fiduciary duties to shareholders seriously, and who need more support from us. It is for those directors that we should act. Most of all, it is for investors that we should act. Today, there is almost $6 trillion invested in mutual funds. I realize that most investors may not appreciate what independent directors do for them. But everyone in this room knows that ultimately, the independent directors are there to watch out for the shareholdersí interests. The mutual fund industry has largely been free of the scandals that have plagued other segments of the financial services industry and we all have a stake in maintaining this unblemished record.
We are pleased that the industry has acted to create a committee to develop best practices for independent fund directors. Working together we can make sure that independent directors have the tools needed to fulfill their role as watchdogs for fund investors. I realize that we and the industry may come up with different solutions on how to enhance the effectiveness of independent directors. But the important thing is that we all agree with this central premise: that enhancing the independence of directors is good for shareholders, and ultimately whatís good for shareholders is also good for the industry. As we move forward on this important initiative, we seek your input and ideas.
Thank you very much.
1 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 the author and do not necessarily reflect the views of the Commission or the author's colleagues upon the staff of the Commission.