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U.S. Securities and Exchange Commission

Speech by SEC Commissioner:
Remarks to the Fifth Annual Advanced ALI-ABA Course on Investment Management Regulation

by Isaac C. Hunt Jr.

Commissioner, U.S. Securities & Exchange Commission

Washington, D.C.

October 22, 1999

Good morning, itís a pleasure and honor to be here today. I appreciate this opportunity to speak to you about the Commissionís recent proposals designed to strengthen the role of independent directors in the corporate governance of mutual funds. But before I begin I am obligated to give you the usual disclaimer that Commission members must make when speaking publicly; which is that the views I express here today are my own and do not necessarily reflect those of the Commission, other Commissioners, or the Commissionís staff.

As you know, fund governance and the effectiveness of independent directors in protecting the interest of fund shareholders have received a great deal of attention this year. There have been articles in the press, roundtable discussions, Commission speeches, and yes even court cases. Why all the fuss? Our mutual fund industry is the envy of the world.

Today, over 77 million individuals own mutual funds. Mutual funds hold over 5 trillion dollars in assets. Investments in mutual funds make up a significant part of most peopleís savings. People invest in mutual funds for their retirements, their childrenís education, and their dreams. It is because of this success that we must be vigilant in ensuring that the foundation of our mutual fund industry is solid; and that begins with corporate governance.

As you know, in February of this year the Commission hosted a roundtable discussion on the role of independent investment company directors. Our goal was simple, how do we improve mutual fund governance. And this month, the Commission issued a set of proposed rules for comment, which, if adopted, I believe would strengthen corporate governance of mutual funds by ensuring that those governing are independent of any conflicts between a fundís shareholders and its investment adviser. We must always remember that a fundís investment adviser works for the fund and its shareholders, not the other way around.

These rule proposals are designed to strengthen the effectiveness of independent directors. As you know, independent directors play a critical role in the governance of mutual funds. While essential and important to the typical corporation, independent directors take on an even greater role in the governance of a mutual fund. For a fund, unlike a typical corporation, generally, has no employees of its own. Rather, its officers and employees are usually employed and compensated by the fundís investment adviser. Consequently, these employees may seek to maximize the profits of the investment adviser rather than the fundís profits. While there are strong economic incentives to serve the fund well, their duties of loyalty and care are owed foremost to the investment adviser and its shareholders. On occasion, this divergent of incentives may lead to conflicts arising between the investment adviser and the fundís shareholders. It is here where independent directors perform their greatest service.

The role of the independent director is to examine these conflicts and resolve them in accordance with the interests of the fundís shareholders. This is not always an easy task. It is even more difficult, however, when independent directors do not compose a majority of a fundís board of directors. In those cases a fundís independent directors may find it difficult, if not impossible, to take the necessary steps to protect the interest of the fundís shareholders.

The importance of having a majority of independent directors also can be seen in the responsibilities that Congress assigned to the board of directors. The Investment Company Act requires a fundís board to evaluate and approve the fundís advisory contract and principal underwriting contract. It also requires the fundís board to select the fundís independent accountants, and in some cases even value the securities held by the fund. In addition, under our rules, directors are responsible for evaluating the reasonableness of advisory and distribution-related fees charged to the fund. These are important responsibilities that help ensure that the fund is operated for the benefit of its shareholders.

The Act, however, only requires that independent directors make up 40% of a fundís board of directors. Thus, in cases where conflicts may exist it may be difficult, if not impossible, for the independent directors to take the necessary action to protect the fundís shareholders. This is not to say that all conflicts result in adverse consequences to a fundís shareholders. We know this not to be the case. In fact, our rules provide for a series of exemptions that would allow certain actions to be taken, despite the existence of a seeming conflict between a fund and its investment adviser.

For example, Rule 10f-3 under the Investment Company Act permits funds to purchase securities in an initial public offering when an affiliated broker-dealer is a member of the underwriting syndicate; Rule 17a-7 permits securities transactions between a fund and another client of the fundís adviser; and Rule 17a-8 permits mergers between certain affiliated funds. These and other rules allow a fund to take certain actions for the benefit of its shareholders despite the appearance of a conflict with affiliated persons or entities.

During the roundtable discussions participants repeatedly noted that one of the most important functions of the independent directors is to oversee conflicts of interests. Although the exemptive rules I just mentioned have expanded the responsibilities of boards in overseeing the conflicts, those rules generally do not contain conditions designed to enhance the independence and effectiveness of fund boards. In light of the recommendations of the roundtable participants, we decided that these exemptive rules should contain some provisions designed to enhance director independence and effectiveness.

Accordingly, our proposals would require that all funds which take advantage of certain exemptive rules (and most do) to adhere to the following practices:

  1. have a majority or super majority of their board of directors to be independent;
  2. have their independent directors select and nominate the other independent directors; and
  3. have any legal counsel used by the independent directors to be independent from the fundís adviser.

Today, most in the industry would consider these to be "best practices." I believe that tomorrow they should be considered minimum practices. By providing for greater independence of the board we believe that material decisions made by the board will consistently prove to be in the interest of fund shareholders despite any appearance of conflict that might indicate otherwise. Moreover, these rule proposals, I believe, will not only benefit fund shareholders but also fund investment advisers. No one ever wants his integrity questioned; itís not only insulting, itís bad for business.

The Commission also believes that additional disclosure about a fundís independent directors is important, given that they are often considered the "watchdogs" for the fundís shareholders. For some time we have been concerned that mutual fund investors do not, in all cases, have access to significant information about fund directors when they need it. Critics have charged that shareholders do not know the very people who are entrusted with safeguarding their interest. Some have complained that fund shareholders do not know whether the interests of the fundís independent directors are aligned with fund management. In reevaluating our disclosure requirements, we noticed that there are several gaps in the information that is available about a fundís directors.

Accordingly, at the same time that we issued our proposed rules on independence we also proposed amendments to our disclosure rules that would require mutual funds to provide the following information to their shareholders:

  1. provide basic information about directors to shareholders annually so that shareholders will know the indentity and experience of their representatives;
  2. disclose to shareholders the number of shares owned by directors in the family of funds or fund complex in order to help shareholders evaluate whether directorsí interests are aligned with their own;
  3. disclose to shareholders information about directors that may raise conflict of interest concerns; and
  4. provide information to shareholders on the boardís role in governing the fund.

These proposals would supplement the information that currently is available in a mutual fundís Statement of Additional Information and in a fundís proxy statements. It is the proposed location of this information that has caused me some concern. If this information is material to existing fund shareholders, and I believe it is, why would it not be material to someone considering initially investing in the fund? Shouldnít this information be in the prospectus that is delivered to prospective investors and used to sell the fund? I know that the Commission has expressed its concern that immaterial information has been cluttering the prospectus but, as noted, I believe that this information is material to both existing and prospective investors. Accordingly, I think this information belongs in the prospectus; but I will keep an open mind and I look forward to reading the comment letters on this issue.

These proposals also would require, for the first time, disclosure regarding a directorís holdings in the fund complex. The goal of this proposal is to indicate to fund shareholders whether the directorsí interests are aligned with theirs. I am concerned, however, that the proposed disclosure may not be very meaningful to shareholders. The disclosure will not tell me whether the director holds shares in my fund or another fund. How is my interest aligned with a director who holds shares in another fund? For example, if I am a shareholder in ABCís growth fund, why would I assume that my interests are aligned with a directorís interest whose only investment is in ABCís fixed income fund? The return of one fund has nothing to do with the return of another fund, even if it is in the same family of funds or fund complex. Moreover, the investment risks associated with one fund will not be the same as those of another fund in the same family but with different investment goals. As proposed, I have doubts as to whether the rule would accomplish its goal of letting investors determine whether the interests of their fundís directors are necessarily aligned with their interests.

Furthermore, I am concerned that at times such disclosure could in fact be misleading. Let me explain. Suppose the disclosure shows that Director X has 1000 shares invested in the ABC complex of funds. And let us assume that in this case the 1000 shares are invested in ABCís growth fund. My investment also happens to be in ABCís growth fund, so it appears our interests are aligned. That is, if ABCís growth fund does well we both do well. Now let us suppose that the portfolio manager for ABCís growth fund resigns. Director X, not having as much confidence in the new portfolio manager, moves his investment from ABCís growth fund to ABCís fixed income fund. The proposed required disclosure, however, would show no change in the Director Xís holdings. It would be mistake for me to continue to believe that my interests and Directorís X interests are aligned.

Therefore, I believe that the proposed disclosure should be made as to the particular fund and not just the fund complex or family. I understand there may be many reasons why a director would choose not to invest in a particular fund, but then why would he or she want to be a director of that fund? Well, I will keep an open mind on this issue as I read the comment letters with great interest.

Thank you for letting me take some of your time to talk about mutual fund governance. As I said in the beginning of my speech, this is an important area and there are to many people relying on us to get it right. I look forward to reading you comments. Thank you.