March 10, 2004
Attention: Jonathan G. Katz
FILE No. S7-03-04
III. Responses to requests for comment
Background The commenterihas been immersed in the Mutual Fund Industry since 1959. It was in that year that a series of events caused him to request and read in detail the Investment Company Act of 1940. At that young and impressionable age he was amazed at the clarity and simplicity of the Act. That impression has stayed with him. In the intervening years he has seen chaos and collapse in the banking industry; of which just two examples are, Continental Illinois Bank gone, Bank of America almost gone. He has seen scandals, disruption, dislocation and financial disaster in the brokerage/securities industry. He has seen the Savings and Loan industry driven to collapse by poor legislation and bad management only to be bailed out by the government. Even the real estate industry suffered periodically and was helped immensely by tax policy. In that same period of time he has seen the mutual fund industry grow from virtually nothing to over twelve trillion dollars. He has seen those assets placed in investments that have contributed magnificently to the capital formation of this country-all with virtually little problem and at comparatively small economic cost, while providing a huge investor class strong economic gains and protection of their savings. Could it be, could it just possibly be that, the Investment Company Act of 1940, it's Amendments, the exemptions thereto, and the resultant codified and non-codified body of rules and regulations, has been effective? The commenter would advance that it has. To change to the Act should be carefully considered. Political expediency should be automatically excluded.
Comment Your very cautious approach to the proposed amendments and the changes to the Investment Company Act of 1940 adopting certain new governance practices of mutual funds is well founded. The proposed changes are revolutionary, not evolutionary. The Act and exemptions there from have provided an outstanding regulatory roadmap. This regulatory roadmap, in conjunction with Management Company (adviser/sponsor) personnel motivated by substantial economic gain, have been responsible for an extremely effective and well regulated industry. The amendments if implemented will cause a disconnect to this highly effective mechanism. They will substitute a cadre of overseers, not as yet identified, and possibly difficult to find, for a well developed, albeit conflicted, governing system that by almost any definition is inherently effective and demonstrably highly successful. The indisputable conclusion to any change in governance must be that it must improve that, which is being governed, not cause harm to it by lessening the quality of governance. The lowering of the quality of governance may be an unintended consequence of the proposed regulatory change.
There is no argument to the fact that certain abuses to the system were uncovered and not by the system itself. The activities were illegal by prospectus definition and unfair to shareholders of those few funds where the transgressions occurred. Inexcusable yes, but the question to be answered is, "Would the proposed oversight system have better served the shareholders"? Clearly, the answer is no. Yes, now with hindsight, the system will alert compliance to the issue and that will be enough to eliminate this particular problem. The question should be would the proposed governance system have a better or lesser chance to uncover the next transgression.
Now, with a Management Company's participation in the Board, and in most cases performing as the de facto lead director or Chairman, other members of the board look to them as the source of all knowledge. Comfort is taken that management's waking days are consumed by system effectiveness and their incomes are directly tied to the system performing as purported. The other board members rely on this incentivized relationship and accept as fact statements, verified by independent audit when required or requested, concerning both system and investment performance.
Let's remove them now from board presence. To whom do the board members look for their information? The independent chairman! How effective is that person? Will he or she have the same knowledge base of the industry, of the Fund, the Fund complex? Will he or she be in constant communication with the administrator, the custodian, the research department, the marketing and advertising departments, the distributor, compliance, with the industry sources in general? Will he or she have the relationship to delve into the sources of information to get the answers the Board needs? More importantly will he or she know the questions to ask? Will those that have the information that is necessary for the Chairperson to be effective cooperate with that person as he might with an insider, especially when Chairperson does not have the ability to fire, hire and reward as the situation requires? Not finally, because there are many other questions, but maybe most important, does the Chairperson have the same incentive, and by this the economic incentive, that drives the conflicted board member/chairman? Clearly he doesn't.
Total independence changes the entire board's relationship to the fund company. Board autonomy brings with it increased perhaps even total responsibility for that for which it is accountable. With that comes increased liability, increase insurance costs. Will that shrink the pool of candidates finding such increase of risk unacceptable? Will the knowledge base of a director now have to be that much greater so there will be fewer qualified candidates? The shareholders will now look to the Board and its members directly, hold them totally responsible performance and administration of the Fund. Does that mean investment management contracts are subject to greater change. Is there a danger to that? Massachusetts Investors Trust was best example of this form of governance. The trustees were very highly compensated. It seems likely the compensation for independent board members will increase. The overall costs to the shareholders will increase unless the increase will be accompanied by a reduction in the management fee paid to the adviser. Staff costs for directors, now covered by the adviser, will be additional charges to the shareholders. Then, if there is a decrease in the adviser's fee, which is highly unlikely, what does this mean for adviser incentive? What happens to the value of a investment management contract? Will that lessen motivation to perform-to effectively market and bring in new assets to spread the shareholder's cost over more assets? What about, too, where foreign organizations own the management companies of mutual funds?
The questions don't stop. Yet to be answered are the questions posed in proposed rule change notification to which these must be added. Unfortunately a simple, off the cuff, plus and minus analysis of all such questions would probably find more marks on the minus side. If the rewards don't substantially outweigh the risks of leaving as is, generally the rule is don't make the change. Particularly don't make a change in response to events that are not of great magnitude. Currently there is much ado about events where several investors out of millions have successfully gamed the system largely due to inattention by a very small number in the industry. Yes, shareholder assets in the form of brokerage commissions have been and will be a continuing question. "12b - 1" fees are an anathema to the industry and should be removed. These are difficult matters and if addressed under the current industry governance structure may be more effectively resolved because of the complexity of these issues. The immediate concern that brought about these proposed changes are more responsive to tough regulatory signals or strong industry and company leadership availing themselves of the regulations under the current governing structure.
The Investment Company Act of 1940 is one of those really well thought out pieces of legislation. It is so effective examining the thinking that went into it is worth consideration. The modifications to date have not changed the basic principles. The super majority proposal is modification whose time may have come. It's a modification. Even an independent chairperson may be acceptable in today's world. It's a modification. It is the combination of the two that makes it more than a modification. It is a distinct change in what appears to be the intention of the creators of the legislation. The writers of the legislation certainly were aware of the Massachusetts Investment Trust format. Could it be they saw some of the problems arising that are discussed above? It is the commenter's belief a more thorough study, by even a small commission consisting of industry people, possibly legislators and various regulators, do an in depth study to understand all the ramifications of the complete independence of the Boards of Investment Companies.
Responses to Requests for Comment
Below are responses to selected items on which you ask the responders to comment.
Should any fund relying on any exempted rules have a board of directors whose independent directors constitute at least 75% of the board?
This is a rule that should be instituted and for reasons you state-to strengthen the hand of the independent directors. It should be phased in. There is no need to go over 75% but there is no need to stay below 75%. Phasing in this requirement is a function of finding qualified directors. There are already too many unqualified directors, or those that do not see the importance of the position they hold.
Should there be a requirement that the chairman of the fund board be an independent director?
This measure is unacceptable and should not be implemented. If elected, all right, but not as a requirement. It is unsupportable because it would materially diminish the leadership of the board and lead to confusion and chaos. Increasing the independent board members to 75% would obviate the need for this change. One exception: in cases where the super majority requirement is waived. This would be a case where this proposal should apply. However, it is suggested it apply with one addition-that the Chairperson in this situation be responsible for all examinations by outside bodies such as the SEC and state regulators.
Consider whether the proposed amendments would strike the correct balance between the management of the fund and that of the role of the independent directors.
The super majority proposal does, the independent chairman does not. The proper balance is struck when the independent directors have the knowledge and therefore the confidence to question the advisor/member of the board. The information and the knowledge the advisor brings to the board is invaluable to the independent directors. To in some way eliminate or reduce that value does not serve the shareholders well. The more appropriate answer is to find more qualified independent directors, and if unavailable, provide directors with the proper training. As part of the acceptance of their directorship to a board of a mutual fund, Directors should be required to become appropriately trained if not already fully qualified for the position. It's that simple. It should be the responsibility of the other board members, independent and adviser, to see that members receive the indoctrination and continuing education. This should be at management fee expense.
Evaluate whether directors have taken on the responsibility of overseeing to many Funds.
There should definitely be a limit to the number of fund company boards one director can serve on. What that number is depends upon the size of the fund, the nature of the fund, its objective, its investment style and the type of fund it is, debt or equity. Whether a director thinks he can handle a great number of funds is incidental. The question is at what point do the shareholders get short changed. The nominating committee that nominates members to the board should determine the number of other boards an independent director can sit on. Therefore it can be patterned to fit each individual situation.
Should we require boards to make (written) self-assessments of their performance?
This matter of self-assessment is difficult to grasp. How does one honestly and objectively grade oneself? There are funds where the investment performance has been so pathetically poor that it borders on criminality. How would those members assess their performance? Having committees of fund boards address certain matters is a separate question and the response is, that if is not already being done in a fund complex then it should be. Yes, the independent board members should meet in a totally separate session, perhaps even removed from the fund complex itself.
Should the independent members of the board have its own staff?
This would be a very complex challenge to an independent board. It would have no idea of where to attain such staff members. It would be a conflict to rely on the adviser or to take staff from the adviser. Therefore, would independent board members have the time to devote to locating and hiring such people? Do they have an administrator that would perform this function? This would be very costly for the fund and the shareholders-and duplicative. It would be something that would take on a life of its own. This would in fact limit the attractiveness to directors to serve on fund boards. The time requirement for them could be a substantial. Board members by definition attend perhaps a quarterly meeting, even the monthly meetings, but this would require additional time to oversee their own staff. A business would probably start to staff many fund companies. This is not a good idea.
Should a Board have its own legal counsel?
This is a good idea. In my career as a chairman I either insisted on having or supplied legal counsel for the Board. This is something that should be mandatory. It is only fair that the independent members of board have availability of their own counsel. Matters Fund Company Directors have to consider are complex subjects. It is only fair to them and the shareholders they receive the appropriate legal guidance.
Please comment on our proposals concerning record keeping
It is inconceivable that the board would fail to acquire and retain the necessary information to make determinations about management fees, to scrutinize the 12 - b1 fee allocation, accounting expense, other fund expenses, and investment performance, just to name a few. Keeping evidence of such Board reviews is not an onerous requirement. It definitely would facilitate SEC and other regulatory examinations. There is nothing in the record keeping proposals that are too costly or burdensome that they should not be undertaken. It is urged that you do accept and encourage such records in electronic form.
Use of outside vendors to accomplish some of the goals being proposed
I have reviewed the Mutual Fund Directors Forum organization and believe it is an excellently staffed and a superior organization to take on providing organizing guidelines of best practices for the board of directors. I think Chairman's Donaldson's request to this organization to provide Directors guidance shows a good deal of wisdom. I believe that this organization can be heavily relied upon to provide much of what Boards need in direction. Having a single organization such as this available to Boards provides for continuity across the industry. In fact many of the issues attempted to be resolved in this proposal could be assuaged through close cooperation with the organization and the expertise it exhibits. I would urge the Securities and Exchange Commission to cultivate this approach.
Consider the additional cost that having independent members of the board as well as a independent chairman of the boards of fund companies.
You did not ask for comment on this issue. Cost considerations have to part of the equation. The more responsibility that you ask independent board members to absorb, the greater number of board members, and the staff support for the boards, the greater you increase the cost to fund shareholders. These are the kind of costs that start innocently and keep increasing as a percentage of assets under management until one day everyone sees them as costs expressed as a higher expense ratio. As an example, a board consisting of all independent members would certainly want protection, and rightfully so, for the increased risk they have to assume. This would increase insurance costs, the amount of time commitments of board members, more ancillary board member cost such as additional travel expense, even in some cases, it might go so far as funding of retirement accounts. I would urge staff of the SEC to consider the cost-benefit ratio of these proposals. I would urge them further to consider where such costs could be recouped at other than on the shareholder level.
And finally, dealing with the law of unintended consequences.
In the early eighties there were less than one hundred mutual funds. The figure referred to today is over five thousand. That growth was prompted by the start of many new funds and complexes. The proposals that are contained concerning Investment Company Governance would substantial raise the bar of entry for new funds. Whether that is good or bad, or something that is the goal of this proposed regulation is not debated here. It's just to point out that many of the dollars invested in these funds are responsible for the industry's growth. Many of these new funds were started in existing Fund complexes. These new, creative, in most cases, better performing funds, came from upstarts, or new sector funds. To obtain directors for such funds under the new proposals would be virtually impossible.
These Comments are Respectfully Submitted by:
Stephen Y. Ascher