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U.S. Securities and Exchange Commission

Speech by SEC Staff:
"Avoiding Complacency, Advocating Reform: The Commission's Independent Fund Directors Initiative"

by Paul F. Roye

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

Before the Investment Company Institute's 1999 Investment Company Directors Conference

Washington, DC

October 28, 1999

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 in this speech are those of the author, and do not necessarily reflect the views of the Commission or other members of the staff of the Commission.

Good afternoon and thank you for inviting me to speak to you today. I am thrilled to have this opportunity to meet with you, the independent directors of mutual funds. For it is independent directors who have been the focus of much of my first year as Director of the SECís Division of Investment Management. And I believe that focus has been appropriately placed.

As you know, independent directors play a unique and crucial role in the mutual fund governance structure. Independent directors serve as the "independent watchdogs": protecting investors, monitoring fund operations and overseeing conflicts of interest. As Justice William O. Douglas said, "[W]e begin and end with the assumption that the directors are trustees by virtue of business ethics as well as law ....." You are the "custodians of the interests" of shareholders.

This system of fund governance, and its reliance on independent directors, have served us well. The industry has grown tremendously, with mutual fund assets up over 580% between 1988 and 1998, while, at the same time, funds largely have been free of the abuses and mismanagement that have beset other financial intermediaries. I believe we owe this good fortune, in large measure, to you, the men and women who are actively committed to serving as energized, thoughtful and aggressive fund directors.

The mutual fund industry cannot rest on its laurels, however. It has been almost 30 years since significant improvements were made to the fund governance structure. And I believe the time for reform is now. Why now? Primarily because there are 77 million Americans who have invested in mutual funds as a way to provide security for their retirement, educational opportunities for their children and income for their financial needs. These investors have tied their livelihoods to funds, and they deserve a fund governance structure that enables independent directors to represent investors from a position of strength and power.

Perhaps a short history lesson will illuminate why I believe it is appropriate for us to move now to strengthen the fund governance structure. You may remember the savings and loan debacle of the late 1980s. The failure of numerous savings and loans cost U.S. taxpayers approximately $165 billion. Norman Strunk, former CEO of the U.S. League of Savings Institutions, the savings and loan equivalent of the ICI, and Fred Case, a UCLA business professor and S&L industry expert, in part blamed the savings and loan debacle on "[d]eriliction of duty on the part of the board of directors of some savings associations," permitting management to make "uncontrolled use" of its authority, "while directors failed to control expenses and prohibit obvious conflict of interest situations." Mr. Strunk and Mr. Case criticized "board complacency" and noted that many S&L directors were "too willing to accept the advice" of management. Mr. Strunk and Mr. Case concluded that S&L directors "acted almost as spectators, content to accept managementís assurances." As we know now, this contentment and complacency was detrimental to S&L depositors and, ultimately, American taxpayers.

We want to be sure that ten years from now fund directors are not spoken of in the same way. 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.

We believe the best way to avoid problems is to improve the system in place. And the way to improve the current system is to support you, the independent directors, and provide you with the tools you need to fully perform your duties -- so that you are not relegated to the role of a complacent spectator, but can act as vigilant guardians of investor interests.

Along these lines, in February of this year, our chairman, Arthur Levitt, hosted a roundtable on the role of fund directors. Panelists at the roundtable included independent directors, investor advocates, executives of fund advisers, academics, corporate governance experts and legal counsel. The roundtable underscored the significant role that independent directors play in protecting fund investors and the seriousness and dedication with which independent directors perform their duties. The roundtable also highlighted possible reforms to improve the ability of independent directors to protect shareholders and focused the attention of the industry and the Commission on enhancing director independence and effectiveness.

Following the roundtable, Chairman Levitt called upon the mutual fund industry to work with the SEC to further enhance the effectiveness of fund directors. The Investment Company Institute responded by establishing an Advisory Group on Best Practices for Fund Directors. The Advisory Group, which included fund executives and independent fund directors, issued its recommendations or "best practices" in June, and the ICI Board of Governors unanimously endorsed the best practices in July. Following this conference, Iím sure you will be even more familiar with these recommendations. We at the Commission applaud this effort by the ICI, and I hope that the boards on which you serve are giving serious consideration to implementation of the best practices. The best practices reflect a recognition of the importance of the independent directorsí role and an industry willingness to further empower independent directors.

As we all know, however, best practices recommendations are just that: recommendations. They can have a strong influence on the industry, but they do not carry the force of law. Furthermore, in many cases, best practices represent a goal, or a fund governance high mark. But they leave open the possibility that many funds will fail to achieve, or even come close to, the mark. Thus, in addition to fund governance goals, we believe there should be a baseline standard which all funds should meet. Therefore, two weeks ago, the Commission proposed its own reforms. In crafting our proposals, we considered all of the Advisory Groupís best practices. Many of the best practices, however, are not reflected in our rule proposals. Several of the best practices relate to matters -- such as retirement policies and the designation of a lead independent director -- that would involve the Commission in micro-managing the operations of fund boards and therefore do not lend themselves to rule proposals, although we have requested comment on this issue. Similarly, as the Advisory Group itself noted, some of the best practices may not be suitable for every fund board.

The Commissionís proposals are designed to enhance the effectiveness of independent directors on a broad level and promote the ability of independent directors to serve as our partners in the protection of fund shareholders. In short, we at the Commission want to assist you in obtaining the tools necessary to do your job better, especially because fund investors rely on you to serve on the front lines in overseeing fund operations and monitoring conflicts of interest. Iíll now briefly discuss some of our major proposals.

Majority of Independent Directors

First, the Commission proposed 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). Now, the Investment Company Act of 1940 contains a minimum independence requirement of 40%. We at the Commission believe, however, that a fund board that has at least a majority of independent directors is better equipped to perform its duties and responsibilities. We believe that the dynamics of the 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 fundís and shareholdersí interests might diverge from the interests of the adviser.

We recognize that the boards of most funds already are composed of a majority of independent directors. We believe, though, that the shareholders of all funds relying on certain conflict-related rules should be afforded this significant protection. The ICI Advisory Group recommended as a best practice that all funds have a two-thirds super-majority of independent directors. The ICI Advisory Group report noted that a two-thirds super-majority should "be more effective than a simple majority in enhancing the authority of independent directors." The Commission therefore proposed the two alternative independence standards and requested comment on the appropriate standard.

Self-Selection and Self-Nomination

A second proposal concerns the self-selection and self-nomination of independent directors. Those of you who serve on the boards of funds with rule 12b-1 plans are familiar with this concept. You have been involved in the selection and nomination of other independent directors. And, hopefully, you have seen that, over time, 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. The ICI Advisory Group Report also recommends that independent directors be selected and nominated by a fundís incumbent independent directors.

The Commissionís proposing release defines selection and nomination as the process by which board candidates are researched, recruited, considered and formally named. This selection and nomination process should give the board an opportunity to consider selecting director candidates that have the right mix of backgrounds, skills and experience to complement those of existing board members. Many of you may have questions about the role that fund management can and should play in the selection and nomination of independent directors. Fund management can be a helpful resource, but the primary responsibility for selecting and nominating qualified and truly independent director candidates should lie with you, the fundsí incumbent independent directors.

Independent Legal Counsel

Another of the Commissionís major proposals is that any person who acts as counsel to a fundís independent directors be an "independent legal counsel." This was one of the proposals that we debated extensively, and some of you may be thinking: why more lawyers? Although I am a lawyer, I do recognize that lawyers can, at times, complicate issues. As Thomas Jefferson once joked, "It is the trade of lawyers to question everything, yield nothing, and to talk by the hour." But seriously, in the context of mutual fund governance, however, I do believe independent counsel for a fundís independent directors is desirable.

As you know all too well, funds are subject to a complex regulatory scheme, which includes federal statutory law, SEC rules and regulations and state corporate law. In addition, because of their unique external management structure, funds encounter conflicts of interest between the fund and its management. In this complex arrangement, an independent director is well served by the assistance of a legal counsel who is truly independent of fund management. Those of you who benefit from the services of independent legal counsel probably wholeheartedly agree. In addition, the guidance of an 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 fundís 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. We are not, however, requiring that independent directors have independent legal counsel. I believe that you, as competent independent directors, can determine for yourselves whether the assistance of independent legal counsel would benefit you in performing your duties. However, given your responsibilities and the complexity of the regulatory structure governing funds, I think independent fund directors would be well advised to have counsel, and counsel who is indeed independent.

The Commission has proposed to define independent legal counsel as any law firm, lawyer (or partner or employee of that lawyer) who has not acted as legal counsel to a fundís adviser, sub-adviser, principal underwriter, administrator (or any of their control persons) since the beginning of the fundís last two completed fiscal years. This independence standard for counsel was derived from the definition of independent director in the 1940 Act. In the alternative, a fundís independent directors could determine that a counselís representation of a fund manager or its control person is or was so limited that it would not adversely affect the counselís ability to provide impartial legal advice. Thus under the proposed definition, you, the independent directors, would not be per se barred from using a particular counsel who has performed some legal work for the management company or its affiliates, but you would have an opportunity to evaluate counselís independence.

I believe that encouraging the use of truly independent counsel by independent directors is one of the strongest pieces of our proposal. Independent counsel is a tool that can facilitate a director performing his or her duties in an informed, competent and diligent manner.

Independent Audit Committees

The Commissionís proposals also seek to enhance director independence by encouraging the development of fund audit committees comprised entirely of independent directors. The ICI Advisory Group made a similar recommendation. Our proposal would exempt funds with independent audit committees from the 1940 Actís requirement that shareholders ratify the selection of a fundís auditor at the next annual shareholder meeting. We believe an audit committee comprised entirely of independent directors provides greater protection to fund shareholders than the rote process of shareholder ratification of the fundís auditor. We recognize that in many fund complexes, independent audit committees play an important role in assuring the integrity of financial statements and the maintenance of internal control systems.

"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 insureds, potentially could exclude claims made by independent directors when they are sued by their fundís adviser. 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. The ICI Advisory Group Report raised similar concerns, and we note that when this issue surfaced in connection with disputes between fund directors and management, ICI Mutual Insurance Company responded quickly to amend its policies to provide coverage to directors in the case of disputes with a fundís adviser.

Qualifications as an Independent Director

Our proposal also contains rules and rule amendments that are designed to prevent qualified individuals from being unnecessarily disqualified from serving as independent directors. We propose to amend a rule that permits directors to be considered independent directors even if they are affiliated with a broker-dealer. I should note that the legislation currently being discussed on the Hill to repeal Glass-Steagall amends the definition of "interested person" to eliminate direct references to being affiliated with a broker-dealer. A person would only be "interested" if affiliated with an entity that effects portfolio transactions for, engages in principal transactions with or distributes shares of the funds in the fund complex. The legislation would also deem a person to be interested if the person is affiliated with an entity that has loaned money or other property to the funds in the complex.

The Commissionís independent directors initiative proposes a new rule that would prevent directors from being disqualified as independent directors solely because they own shares of index funds that hold limited interests in their fundís adviser or principal underwriter.

Staff Interpretations

In addition to these rule proposals, the Commissionís independent directors initiative includes staff interpretive positions designed to enhance the position of independent directors. These interpretive positions are immediately effective, unlike the rule proposals which are simply proposals at this stage and do not have the force of law at this time. Comments on the rule proposals are due to the Commission by January 28, 2000, and we encourage you to comment on these proposals.

Some persons have questioned whether fund directors have the authority to use fund assets to participate in a proxy fight with a fundís 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 Commissionís 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 Actís limits on indemnification of legal fees for willful misfeasance, bad faith, gross negligence or reckless disregard of duties. These interpretations, along with the elimination of "insured versus insured" exclusions in joint D&O/E&O policies, hopefully will ease independent directors of any concerns regarding your ability to act in shareholdersí 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. The ICI Advisory Group also recommended that fund directors invest in funds on whose boards they serve. A directorís 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. From a practical perspective, nothing energizes a director to monitor fund management and oversee fund operations like the knowledge that the directorís own money is on the line.

Commissionís Role in Disputes

The Interpretive Release also contains a position issued by the Commission which involves the Commissionís role in disputes between independent directors and fund management. This has been an area of recent concern for fund directors and was an issue raised repeatedly at the roundtable. Silence on the part of the Commission in disputes between fund directors and management should not be equated with inaction. As a matter of policy, the Commission is limited in its ability to comment publicly on allegations of wrongdoing, and following a full investigation by the staff, SEC enforcement actions may not be warranted in certain situations, even when the information available to the public may indicate that a federal securities law violation has occurred. At the same time, the Commission does take any allegation of wrongdoing seriously, especially when those allegations are asserted by independent directors. Furthermore, as we have discussed, the Commissionís initiatives are designed to better define the watchdog role of independent directors and give independent directors the tools you need to interact effectively with management. Hopefully, this will limit the occasions of full scale dispute and litigation between fund directors and fund management.

Director Education

The strengthening of independent directors does not end with rule proposals and interpretations. In fact it begins, first and foremost, with independent directors like you, who are committed to learning more and staying abreast of issues. Your attendance at conferences such as this, even though you have full calendars and competing commitments, indicates a willingness on your part to "receive appropriate orientation and . . . keep abreast of industry and regulatory developments" as the ICI Advisory Group recommended. I also applaud the commitment the ICI has made over the years to organizing conferences such as this one, which are designed to enhance directorsí ability to perform their duties. Along these same lines, we at the Commission were pleased that former SEC chairman David Ruder recently announced the formation of the Mutual Fund Directors Education Council to promote the development of educational programs for fund directors. I encourage you to continue to support and participate in these worthwhile continuing education efforts.


I hope you agree with me that many of 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 SECís 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, you may not remember every specific provision of the 1940 Act or applicable rule or law, but 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.