Dissent of Commissioners Cynthia A. Glassman and Paul S. Atkins
Investment Company Governance, Release No. IC-26520
We write jointly to dissent from the Commission’s adoption of amendments to rules under the Investment Company Act of 1940 (“Investment Company Act” or “Act”) that generally require a fund’s board of directors: (1) to be composed of directors, at least 75 percent of whom are independent, and (2) to be led by an independent director as its chairperson.1 We support the rulemaking’s commendable objective of strengthening investor protection for fund shareholders. However, we fear that the path chosen to achieve this objective may lead in the opposite direction — at a substantial cost to fund shareholders. Because the fund industry is a $7.6 trillion industry, it is easy to ignore or lose sight of the fact that the costs of regulatory requirements are ultimately paid by fund shareholders, for whom small differences in fees are of great importance.2
As the release indicates, although the benefits of the amendments are difficult to quantify, a majority of the Commission “believe[s] they are real.”3 The majority postulates that the new independence requirements will “strengthen the hand of the independent directors when dealing with fund management, and may assure that independent directors maintain control of the board and its agenda.”4 However, despite the existence of empirical data that could have been analyzed to evaluate potential benefits, the proponents provided no such analysis. Moreover, the majority speculates sanguinely that the benefits of these amendments will come at “minimal” cost to funds.5 Positing that empirical evidence is unnecessary, the majority dismisses pleas for more deliberate action.6 A particular standard of independence is not, in and of itself, a legitimate regulatory objective. Therefore, before we mandate that all funds meet any particular independence standard, it must be objectively linked (by more than anecdotal evidence and “gut impression”) to real benefits for shareholders.
Existing Independence Requirements are Sufficient to Ensure Meaningful Influence
Existing statutory and regulatory requirements already ensure that independent directors can make their voices heard and heeded. In enacting the Investment Company Act, Congress prescribed a fund board’s independence requirements. Section 10(a) of the Investment Company Act requires that at least forty percent of a fund’s board be independent.7 Section 10(b)(2) of the Act requires, in effect, that independent directors comprise a majority of a fund’s board if the fund’s principal underwriter is an affiliate of the fund’s adviser.8 Moreover, certain board actions cannot be taken without approval by a majority of the independent directors. Most importantly, section 15(c) provides that a majority of the independent directors must approve advisory and underwriting contracts.9 Certain Commission exemptive rules also require a majority vote by the independent directors in specific areas of conflict.10 In addition, three years ago the Commission conditioned ten of its commonly-used exemptive rules on fund boards’ having a majority of independent directors.11 These rules are the same rules the Commission is amending today.12
The existing independence requirements already enable independent directors to set the agenda and determine the outcome of decisions made by the board.13 As the Commission noted three years ago, a majority requirement is sufficient to “permit, under state law, the independent directors to control the fund’s ‘corporate machinery,’ i.e., to elect officers of the fund, call meetings, solicit proxies, and take other actions without the consent of the adviser.”14 “[I]ndependent directors who comprise the majority of a board can have a more meaningful influence on fund management and represent shareholders from a position of strength.”15 A majority of independent directors also can insist, if they determine that it would be beneficial, on an independent chairperson.
We are particularly troubled that the Commission has not shown that the reforms from three years ago were inadequate to achieve the stated goals. The new independence conditions took effect on July 1, 2002, so the Commission has allowed itself only two years to observe the effects of the amendments. Most importantly, the Commission has not even attempted the barest systematic assessment of the effectiveness either of those reforms or, more generally, of the statutory and rule-based fund governance requirements. We are also troubled that at the same time the majority raises the requirement for the number of independent directors, it notes that the directors who are legally “independent” may not really be independent.16 The majority’s concerns suggest a possible need for a change in the statutory definition of “interested person” under section 2(a)(19) of the Act rather than for an increase in the number of independent directors.17
A Seventy-five Percent Independence Threshold is Unnecessary
The majority’s choice of seventy-five percent is puzzling. The majority points to the only section in the Investment Company Act that dictates this percentage, section 15(f).18 The majority does not explain that section 15(f) is a safe harbor provision that “make[s] clear that an investment adviser can make a profit on the sale of its business subject to two principal safeguards to protect the investment company and its shareholders.”19 Congress did not intend for it to serve as a universally-applicable requirement for fund boards.
The Commission could have imposed a two-thirds independence requirement, which most funds already satisfy, is consistent with best practices recommendations from the Investment Company Institute,20 and was contemplated (but rejected in favor of a majority requirement) in connection with the 2001 fund governance changes.21 Instead, the majority has chosen a seventy-five percent minimum, which forces approximately half of funds to make changes.22 Again, the majority fails to give any real consideration to the costs of this change. The Adopting Release acknowledges that “our staff has no reliable basis for determining how funds would choose to satisfy [the seventy-five percent] requirement and therefore it is difficult to determine the costs associated with electing independent directors.”23 Fund boards are able to avoid incurring the costs of hiring new independent directors by reducing the number of directors, but even this approach is likely to impose some costs, not the least of which is the loss of the insight and experience of directors who are removed from the board. Funds that conclude that it is in the interest of fund shareholders to retain existing interested directors will need to hire additional independent directors, a costly prospect.24
Mandating an Independent Chairperson is Unwarranted
The rulemaking is characterized as being part of the solution to the late trading, market timing, and other fund abuses that have come to light over the past year. Its proponents claim that the enforcement cases we have brought to date in this area exhibit a telling pattern – approximately eighty percent of the funds involved had inside chairpersons.25 However, because approximately eighty percent of all fund firms have interested chairpersons, this number suggests only that funds with inside chairpersons are proportionally implicated in the abusive activity. A common feature of these enforcement actions is that boards were not told of the formal or informal arrangements permitting market timing. An inside chairperson with access to information about day-to-day operations might be more likely than an independent chairperson to discover practices that are harmful to fund shareholders.26
When the amendments were proposed, we asked that a more thorough analysis be undertaken before effecting these significant changes in an industry that is of such importance to so many investors.27 Proponents of the rule undertook no such analysis, and the Commission did not use its resources to conduct such an analysis. The burden of proof lies with the regulator seeking to overturn the status quo rather than with the regulated.28 The empirical data we did receive suggest that the amendments might not be beneficial. The data show a correlation between an inside chairperson and superior performance and no statistically significant negative effect on fees.29 Indeed, many of the funds that report the best performance and lowest fees have inside chairpersons.30
A fact largely ignored by this rulemaking is that independent directors are not the only ones charged with protecting the interests of fund shareholders. An investment adviser has a fiduciary duty to act in the best interests of a fund it advises.31 Further, all fund directors have a fiduciary duty to shareholders.32 It is true that fund managers serve two constituencies -- shareholders of the adviser and shareholders of the fund. The interests of these two groups are not, however, entirely at odds. Interested fund directors have an incentive to maximize fund performance because good performance matters to fund investors, who factor it into their investment decisions. Thus, market forces compel fund advisers to offer fund shareholders good performance for a reasonable fee in order to preserve the integrity and hence, marketability, of its brand. This rulemaking overlooks these market forces and seems to suggest that there is no counterweight to the pressure to impose fees on the fund.
Concluding nonetheless that investors would benefit from an independent chairperson, the majority ignores the costs fund investors will bear by the adoption of this requirement.33 The majority did not identify “any out-of-pocket costs” associated with the independent chairperson requirement. Yet an estimated eighty percent of funds will need a new chairperson. If a sitting independent director accepts the position, the fund will need to pay him more to accept the new responsibilities.34 If none of the sitting independent directors wants the job or none is qualified,35 the fund will need to launch an expensive search. It may be difficult for funds to find an individual with the requisite industry experience whom they can afford to hire.
Moreover, in order to be effective at carrying out his or her responsibilities, an independent chairperson likely would have to hire a staff.36 The majority addresses this issue only in passing by stating that the “staff is not aware of any costs associated with hiring employees or retaining experts because boards typically have this authority under state law, and the rule would not require” that an independent chairperson hire employees.37 We cannot support a rule that rests upon such tortured logic and circular reasoning. As some commenters have noted, it is ironic that the majority, in its zeal to strengthen the independence of fund boards, has enacted a measure that takes away that independence of the board to select its own chairperson.38
The Commission Failed to Examine Alternatives
We fear that the Commission is acting simply to appear proactive. The Commission already has taken significant steps to address the recently uncovered abuses in the fund industry and to identify and address other potentially problematic issues. We have brought enforcement actions under existing laws and regulations to punish the wrongdoers.39 We have also initiated meaningful regulatory reform. Recently, for example, we adopted requirements regarding the disclosure of market-timing policies,40 enhancing the disclosure provided by funds about how their boards evaluate and approve investment advisory contracts,41 and requiring funds and advisers to designate chief compliance officers.42 In addition, we are considering initiatives on fair value pricing,43 increased transparency of fund transaction costs and expenses,44 pricing of fund shares,45 and fund distribution arrangements.46
We were hopeful when these board governance amendments were proposed that alternative measures would be considered. Requiring a fund to disclose prominently whether or not it had an independent chairperson, for example, would allow shareholders to decide whether that matters to them or not. Alternatively, we could have endorsed the lead independent director concept by requiring a fund’s independent directors to appoint a lead director to represent the views of the fund’s independent directors to fund management.47 We could have required additionally that each major board committee be chaired by an independent director, who would have the authority to set the agenda of the committee. The advantage of these alternatives, in addition to being less costly, is that they leave the decision about the independent chairperson to the independent directors or the marketplace, rather than impose the requirement by regulatory fiat. The majority failed to give serious consideration to these alternatives.48
Under the cover of “good atmospherics” and the shroud of “investor protection,” the majority has decided to adopt measures the benefits of which are illusory, but the costs of which are real. We conclude that the majority has not justified this forced restructuring of the corporate governance of the vast majority of funds and fear that it provides investors with a false sense of security.
For the foregoing reasons, we respectfully dissent.
Cynthia A. Glassman, Commissioner
Paul S. Atkins, Commissioner
1 The change is effected by making these governance requirements conditions of ten commonly used exemptive rules. Because these rules are used by virtually all funds, these requirements are effectively universally applicable.
2 See, e.g., Securities and Exchange Commission, Invest Wisely: An Introduction to Mutual Funds (available at: http://www.sec.gov/investor/pubs/inwsmf.htm#key) (“Even small differences in fees can translate into large differences in returns over time. For example, if you invested $10,000 in a fund that produced a 10% annual return before expenses and had annual operating expenses of 1.5%, then after 20 years you would have roughly $49,725. But if the fund had expenses of only 0.5%, then you would end up with $60,858 — an 18% difference.”).
3 See Section VI.A of the Adopting Release (“Benefits”).
4 See Adopting Release, text accompanying note 75.
5 See Section VIII of the Adopting Release (Consideration of Promotion of Efficiency, Competition and Capital Formation”).
6 See Securities and Exchange Commission, Open Meeting Webcast, June 23, 2004 (available at: http://www.sec.gov/news/openmeetings.shtml) (dissenting views on the value of empirical data).
7 See section 10(a). 15 U.S.C. 80a-10(a). Congress initially considered, but later rejected a majority independence requirement because of concerns “that if a person is buying management of a particular person and if the majority of the board can repudiate his advice, then in effect, you are depriving the stockholders of that person’s advice.” Investment Trusts and Investment Companies: Hearings on H.R. 10065 Before the House Subcomm. on Interstate and Foreign Commerce, 76th Cong., 3d Sess. 109-110 (1940) (testimony of David Schenker). Since approximately 90 percent of funds utilize these exemptive rules, the majority is effectively mandating these changes for all funds. See Adopting Release at note 88. Given the clearly stated, legislatively prescribed independence mandates, we question whether the Commission is acting outside its authority under the Investment Company Act.
8 15 U.S.C. 80a-10(b)(2). See also section 10(c) (a majority of the board of a registered investment company may not consist of persons who are officers, directors, or employees of any one bank or bank holding company).
9 15 U.S.C. 80a-15(c). See also section 32(a)(1) of the Act (a fund’s auditor must be selected by the vote of a majority of the fund’s independent directors).
10 Rule 17a-7, for example, requires that fund directors, including a majority of the independent directors, determine at least quarterly that all affiliated purchase and sale transactions were made in compliance with procedures adopted by the board, including a majority of the independent directors. 17 CFR 270.17a-7.
11 Role of Independent Directors of Investment Companies, Investment Company Act Release No. 24816 (Jan. 2, 2001) [66 FR 3734 (Jan. 16, 2001)] (“2001 Adopting Release”).
12 See Adopting Release at note 8.
13 Last year, the staff noted the power already possessed by fund independent directors: “[A]lmost all funds have boards with at least a majority of independent directors. Thus, one could question whether there is a need to mandate that a fund’s chairman be independent because independent directors representing a majority of a fund’s board already are in a position to control the board and, if they deemed it appropriate, could already influence the agenda and the flow of information to the board.” Memorandum from Paul F. Roye, Director, Division of Investment Management, to William H. Donaldson, Chairman, SEC, re Correspondence from Chairman Richard H. Baker, House Subcommittee on Capital Markets, Insurance and Government Sponsored Enterprises, at 50 (June 9, 2003) (available at: http://financialservices. house.gov/media/pdf/02-14-70%20memo.pdf) (“Baker Memorandum”).
14 2001 Adopting Release at text accompanying note 22.
15 2001 Adopting Release at text accompanying note 23.
16 See Section II.C of the Adopting Release.
17 “Independent director” is a term commonly used to refer to a director who is not an “interested person” as defined in section 2(a)(19). 15 U.S.C. 80a-2(a)(19). The Commission, of course, would need to petition Congress for such a change. Indeed, last year the staff asked Congress to consider revising section 2(a)(19) of the Act to give the Commission “rulemaking authority to fill gaps in the statute that have permitted persons to serve as independent directors despite relationships that suggest a lack of independence from fund management.” See Baker Memorandum, supra note 13, at 47.
18 15 U.S.C. 80a-15(f). Section 15(f) requires funds to maintain boards comprising at least seventy-five percent independent directors for the three-year period after an adviser has sold its advisory business to another entity. This provision was added by Congress to limit the effects of Rosenfeld v. Black, 445 F.2d 1337 (2d Cir. 1971). In that case, the court had held that it was a violation of an adviser’s fiduciary duty to transfer an advisory contract to another adviser for profit.
19 Committee on Banking, Housing and Urban Affairs, Report No. 94-75 to Accompany S. 249 (Apr. 14, 1975).
20 See Investment Company Institute, Report of the Advisory Group on Best Practices for Fund Directors: Enhancing a Culture of Independence and Effectiveness at 10-12 (June 24, 1999) (available at: http://www.ici.org/pdf/rpt_best_practices.pdf).
21 See 2001 Adopting Release at note 25. The majority, conceding that “there are good arguments for maintaining a management presence on the board,” portrays itself as reasonable because it rejected the higher independence percentages recommended by some commenters. See Adopting Release at note  and accompanying text (citing Letter of Tom Walker to Jonathan G. Katz, Secretary, SEC (Mar. 9, 2004), File No. S7-03-04 (“While your changes are moving in the right direction in advocating for a more independant [sic] boards. I believe it still allows for too much room for cornyism [sic] and nepotism to play out on what should be truley [sic] independant [sic] directors.”); Letter of John and Judy Hesselberth to Jonathan G. Katz, Secretary, SEC (Feb. 24, 2004), File No. S7-03-04 (“In addition the requirement that 75% of the directors of a mutual fund must be outside directors is sound. It probably should be 100%, but 75 is a step in the right direction from the current 50%.”).
22 See Letter from Craig S. Tyle, General Counsel, Investment Company Institute, to Jonathan G. Katz, Secretary, SEC (Mar. 10, 2004), File No. S7-03-04 (stating that “a change from the current [common industry] practice of a two-thirds supermajority to a seventy-five percent requirement would mean that at least half of all fund boards would have to change their current composition, according to Institute data.”).
23 Adopting Release at text accompanying note  (footnote omitted).
24 A survey found that in 2002, the median compensation for independent directors at the 50 largest fund groups was $113,000 a year and at the smaller fund groups was $18,000. See Rick Miller, In Off Year, these Cats Get Fatter: Fund Board Directors Collect a Big Pay Raise, Investment News, April 7, 2003, at 1 (reporting results of a survey conducted by Management Practice Inc.). This amount, of course, does not include up-front search costs and annual non-compensation costs associated with a director’s performance of his or her duties.
25 See, e.g., Letter from Congressman Michael G. Oxley to Chairman William H. Donaldson (May 20, 2004).
26 In pointing out this and other potential benefits that an interested chairperson might bring to a fund board, we do not intend to suggest that all boards should select an interested chairperson. To the contrary, we maintain that what works well for one fund board might not work well for every other fund board. Under certain circumstances, a fund board might conclude that an independent chairperson is essential. See, e.g., Tom Lauricella, Strong Steps Down from Fund Board but Stays on as Head of Firm, Wall St. J., Nov. 3, 2003, at C12 (reporting that following Richard Strong’s resignation from his post as chairman of the board of the Strong Mutual Funds, “[t]he independent Strong directors have begun a search to replace Mr. Strong with a chairman who is independent from Strong Capital management”).
27 At the Commission Open Meeting during which the Commission voted to propose the amendments, Commissioner Glassman requested that proponents and/or staff provide empirical data that would support the amendments.
28 The application of “Total Quality Management,” the management philosophy of W. Edwards Deming, and a later variant, “Six Sigma,” would emphasize the importance of discerning whether the fund advisers’ fraudulent activity (the variation from desired results) derives from a common cause or something aberrant in a particular adviser’s management process – that is, a special cause. If common causes are to blame for the fraudulent activity, then the system is flawed and redesign is necessary. Special causes require more targeted solutions. As discussed below, the fact that funds with independent chairpersons seem proportionally implicated in this fraudulent activity indicates that the lack of an independent chairperson is not a common cause for the fraudulent activity by fund advisers. In addition, the empirical data that we have found this far supports this observation. Consequently, a redesign of the fund governance system is not indicated by the data. The majority’s redesign of the system will not, and cannot be expected to, cure the flaws of the system.
29 See Geoffrey H. Bobroff and Thomas H. Mack, Assessing the Significance of Mutual Fund Board Independent Chairs, A Study for Fidelity Investments (Mar. 10, 2004) (attached to letter from Eric D. Roiter, Senior Vice President and General Counsel, Fidelity Management & Research Company to Jonathan G. Katz, SEC (Mar. 10, 2002), File No. S7-03-04)). In an effort to support its position and rebut challenges that it has not considered any empirical evidence, the majority laments the fact that commenters did not submit any pre-existing studies and dismisses the findings of this study, which was commissioned in response to the Commission’s request for comments on the proposed amendments. See Adopting Release at note 51. The majority’s intimation that the data must be discounted because of the “prevalence of independent chairmen among bank-sponsored fund groups” is troubling if it is intended to suggest that bank-sponsored mutual funds are inherently inferior to their non-bank counterparts. We acknowledge that one study cannot conclusively resolve the debate about independent chairpersons, but its conclusions contribute to the debate. Boards of directors, not the Commission, should weigh the evidence to decide whether an independent chairperson would be beneficial for their fund shareholders.
31 See Rosenfeld v. Black, 445 F.2d 1337 (2d Cir. 1971); Brown v. Bullock, 194 F. Supp. 207, 229, 234 (S.D.N.Y.), aff'd, 294 F.2d 415 (2d Cir. 1961). See also Section 36(b) of the Investment Company Act [15 U.S.C. 80a-35(b)] (investment adviser of a fund has a fiduciary duty with respect to the receipt of compensation paid by the fund). More generally, investment advisers owe a fiduciary duty to their clients. SEC v. Capital Gains Research Bureau, 375 U.S. 180, 191 (1963) (interpreting Section 206 of the Investment Advisers Act of 1940).
32 In addition to standard state law duties applicable to all corporate directors, fund directors have fiduciary duties under the Investment Company Act. See Section 36(a) of the Investment Company Act. 15 U.S.C. 80a-35(a).
33 See Section VI.B (“Costs”) of the Adopting Release.
34 According to one estimate, an independent chairperson could command a 25 to 50% premium over other board members. See Beagan Wilcox, Wanted: Independent Chairmen, Board IQ, July 6, 2004 (citing estimate of Meyrick Payne, senior partner, Management Practice).
35 Independent directors have “diverse backgrounds in business, government or academia.” Investment Company Institute, Understanding the Role of Mutual Fund Directors, at 6. Fund independent directors without experience in the fund industry can apply their experiences in other areas to perform their responsibilities as independent directors, but may not be adequately equipped to handle responsibilities of board chairperson.
36 Of necessity, both the independent chairperson and his or her staff are likely to be dependent on fund management and, therefore, may lose independent perspective on matters facing the board. Sir Derek Higgs recognized this in his review of corporate governance in Britain. See Derek Higgs, Review of the Role and Effectiveness of Non-Executive Directors (Jan. 2003) at 24 (explaining that, even if a chairperson is independent prior to appointment, thereafter he or she will work closely with management in carrying out his or her duties, so “[a]pplying a test of independence at this stage is neither appropriate nor necessary.“).
37 See Section VI.B (“Costs”) of the Adopting Release.
38 The majority reassures independent directors that the amendments “do not prevent the independent directors from choosing the most qualified and capable candidate.” See Adopting Release, at text following note 47. We contend that a conscientious board might reasonably determine that the most qualified and capable candidate is someone with the deep familiarity with day-to-day fund operations. The majority apparently believes they know better.
39 See Adopting Release at note 5.
40 Disclosure Regarding Market Timing and Selective Disclosure of Portfolio Holdings, Investment Company Act Release No. 26418 (Apr. 19, 2004) [69 FR 22300 (Apr. 23, 2004)].
41 Disclosure Regarding Approval of Investment Advisory Contracts by Directors of Investment Companies, Investment Company Act Release 26486 (June 23, 2004) [69 FR 39798 (June 30, 2004)].
42 Compliance Programs of Investment Companies and Investment Advisers, Investment Advisers Act Release No. 2204 (Dec. 17, 2003) [68 FR 74714 (Dec. 24, 2003)].
43 These initiatives are described in Mandatory Redemption Fees for Redeemable Fund Securities, Investment Company Act Release No. 26375A at Section II.F (Mar. 5, 2004) [69 FR 11762 (Mar. 11, 2004)].
44 See Confirmation Requirements and Point of Sale Disclosure Requirements for Transactions in Certain Mutual Funds and Other Securities, and Other Confirmation Requirement Amendments, and Amendments to the Registration Form for Mutual Funds, Investment Company Act Release No. 26341 (Jan. 29, 2004) [69 FR 6438 (Feb. 10, 2004)] and Request for Comments on Measures to Improve Disclosure of Mutual Fund Transaction Costs, Investment Company Act Release No. 26313 (Dec. 18, 2003).
45 Amendments to Rules Governing Pricing of Mutual Fund Shares, Investment Company Act Release No. 26288 (Dec. 11, 2003) [68 FR 70388 (Dec. 17, 2003)].
46 Prohibition on the Use of Brokerage Commissions to Finance Distribution, Investment Company Act Release No. 26356 (Feb. 24, 2004) [69 FR 9726 (Mar. 1, 2004)].
47 In 1999, the Investment Company Institute’s Advisory Group on Best Practices for Fund Directors included among its recommendations the designation of one or more persons as a lead director. See Investment Company Institute, Report of the Advisory Group on Best Practices for Fund Directors: Enhancing a Culture of Independence and Effectiveness at 25 (June 24, 1999) (available at: http://www.ici.org/pdf/rpt_best_practices.pdf).
48 The majority acknowledged that these alternatives could be useful, but explained that funds would have difficulty finding persons of “sufficient stature” to act as “an effective counterweight to a fund chairman who may also be the chief executive officer of the management company.” See Adopting Release at text accompanying note 57. We question whether funds will find it easier to fill the position of independent chairperson with a person able both to act as an “effective counterweight” and also to fulfill the routine administrative responsibilities of running a fund board.