Opportunity Partners L.P., 60 Heritage Drive, Pleasantville, NY 10570
(914) 747-5262 // Fax: (914) firstname.lastname@example.org
March 14, 2004
Jonathan G. Katz
Securities & Exchange Commission
450 Fifth Street N.W.
Washington, DC 20549-0609
Re: File No. S7-03-04 Investment Company Governance
Dear Mr. Katz:
In the summer of 1967, some friends and I rented an apartment in Cape Cod. One day, a girl brought us a turtle she found at a nearby stream. She put the turtle on the floor to let it acclimate itself to its new home. But the turtle was frightened and proceeded to walk to the nearest wall. It tried to climb up the wall for what seemed like hours but it never succeeded because turtles cannot climb walls. Eventually, we felt sorry for the poor frustrated critter and put it back by the stream.
Like our turtle, the Commission seems to be unable to grasp a basic truth, i.e., without appropriate incentives, tinkering with the governance structure of a fund cannot transform unwilling so-called independent directors into effective monitors of management. The Commission's premise that "[t]he effectiveness of a fund board and the influence of its independent directors depend on both the quality of the directors and the governance practices they adopt" is flawed because it omits a crucial term in the equation, i.e., whether the independent directors are sufficiently motivated "to better serve as an effective check on fund management."
Five hundred years ago, Niccolo Machiavelli observed that the most effective motivating force for most people is fear. Generally, fund directors that rubber stamp management's actions have little to fear while confronting management can lead to unpleasant consequences. For example, since Eliot Spitzer first revealed the collusion between several mutual fund managers and some large investors, I have not heard of even one independent director being sanctioned for failing to take action against an investment advisor that breached its fiduciary duty to the fund. At the same time, the rare director that does take action against an errant advisor risks serious financial repercussions.1 Here is a fundamental truth. Even if every director of a fund is nominally independent, few of them are likely to act as watchdogs for shareholders unless they fear the consequences of being a rubber stamp for management more than they fear the consequences of confronting management.
The job of a fund director reminds me of a scene in a Western movie in which the town's corrupt mayor (played by someone like Gene Hackman) slaps a sheriff's badge on some docile citizen and tells him his salary will be $50 a month "as long as things run smoothly." The message is clear: "You owe your job to me and I don't want any trouble." The new sheriff has little motivation to challenge the person responsible for giving him his job.
Similarly, fund directors have little incentive to confront the management firm that appointed them as "watchdogs." The Commission's proposal seeks to give the "watchdog-sheriffs" the equivalent of a better horse and gun and a few deputies with the expectation that these "tools" will enable them to do a better job. But without the appropriate incentives, the proposal, like the one adopted in 19992, will produce no beneficial effects for anyone except fund lawyers who will be need to get paid with fund assets to "advise" boards on the new rule's intricacies.
As the Commission knows, a majority of almost every fund board is already comprised of independent directors. Nothing is preventing them from voting right now to implement every single element of the Commission's proposal. The fact that they have not done so and that they have not supported the proposal is evidence of their lack of commitment to the spirit of the proposal. If the very persons the Commission claims it relies upon to "manage conflicts of interest that the fund adviser inevitably has with the fund" do not support it, how realistic is it to expect the proposal to lead to meaningful change?
Incidentally, the silliest part of the proposal is the requirement that the directors perform an annual self-evaluation. When has a mandated self-evaluation exercise ever led to anything but useless CYA boilerplate? But, go ahead and adopt it. At least we will see once and for all how prevalent the Lake Wobegon effect3 is in boardrooms.
The only worthwhile element of the Commission's proposal is to authorize (but not require) a director to engage legal counsel at the fund's expense if he or she suspects wrongdoing on the part of management. That is a tool that any well-intentioned director needs if he is outnumbered on the board. For example, because I did not have the authority to hire counsel at the fund's expense, I personally incurred almost $300,000 in legal expenses to vindicate the franchise rights of shareholders of a closed-end fund on whose board I serve. After I obtained a favorable settlement for the shareholders, the Commission has made me jump through hoops and spend more money on lawyers to permit me to be reimbursed for my legal expenses - and there is no guarantee that it will do so. That sends the wrong message to any director that might be similarly inclined to stand up for shareholders. A director should not have to dig into his own pocket to fulfill his fiduciary duty to shareholders.
But for that sole exception, it is unlikely that any of the proposed governance requirements will have a beneficial effect on funds or their shareholders. Unsurprisingly, that is surely why the Release is devoid of evidence that the rule will have the desired effect. Instead, words like "may," "could," and "believe" are used many times in the Release. For example: "The proposed amendment . . . may encourage independent directors to request more information, and this information may enable them to obtain more favorable terms in advisory contracts." (emphasis added) Speculation without any factual support is not a sound basis for rulemaking
"OK, smart guy," you may be thinking. "If you are right that our proposal won't have a meaningful impact on corruption by fund management companies, what should the Commission do?" I am glad you asked. Here are a few suggestions.
It is understandable that the Commission feels enormous pressure to respond to the recent revelations of widespread corruption in the mutual fund industry. Still, that does not justify adopting a rule that is itself illegal. I submit that the proposed rule, by improperly tacking on a series of fund governance conditions to ten exemptive rules, constitutes overreaching by the Commission into the legislative arena.
For example, a practice which is generally illegal under the Investment Company Act is using fund assets to pay distribution expenses. However, Rule 12b-1 permits a fund to do so if certain conditions are met. Now, the Commission proposes to add new governance requirements to Rule 12b-1 but without indicating (a) that the rule is not adequate in its existing form, (b) how the additional requirements are related to the concerns that led the rule to be originally adopted and (c) how the additional requirements will deter the possibility of abuse related to the use of fund assets to pay distribution expenses.
As the Release makes clear, the Commission thinks the proposed governance requirements should apply to all funds. Fair enough. Why then does it not simply require all investment companies to adopt them? The answer must be that it does not the authority to make such a rule. But if the Commission cannot adopt such a rule on its own merits, can it simply graft it on to an unrelated exemptive rule that "almost all funds either rely or anticipate someday relying on?" Are existing exemptive rules appropriate vehicles to mandate requirements that the Commission favors but lacks the authority to impose directly on all funds? I don't think so even though it is unlikely that any fund would risk incurring the wrath of the Commission by failing to comply with them. Nevertheless, the Commission should not evade the law by doing indirectly what it cannot do directly4 even if it is well-intentioned.
If the proposed rule is likely to be ineffective and rests on shaky legal grounds, why not just junk it? That also goes for the many other rules the Commission has proposed in the wake of the mutual fund scandals. It is clear to me that every reported incident of fund management personnel knowingly permitting stale pricing arbitrage (or engaging in it themselves) to the detriment of long-term shareholders is a breach of fiduciary duty punishable under Section 36 of the Investment Company Act regardless of what the fund's prospectus says. Therefore, it is unnecessary to add any new rules to combat corruption in the mutual fund industry.5 All the Commission has to do is aggressively enforce Section 36 and impose heavy penalties on those found guilty of betraying the trust of fund shareholders. A $400 million fine imposed on Richard Strong if he is found to have gamed his own funds to the detriment of long-term investors will do much more to deter bad behavior by fund fiduciaries than a hundred new rules. The free market also does a pretty good job in punishing corrupt fund managers when they are exposed as the folks running funds at Putnam, Janus, Alliance and Invesco have learned.
In sum, I think Machiavelli would agree with me that the Commission's goals will more likely be realized if it focuses its energies on instilling fear in the minds of unethical managers by vigorously enforcing the existing laws and rules rather than on making new rules.
Very truly yours,
Kimball & Winthrop, Inc.
1 When the independent directors of the Yacktman and Navallier fund complexes tried to do something about management's misdeeds, the directors soon found themselves out of a job.
2 Unless I missed it, the Release said nothing about whether the Commission's 1999 rule mandating that board be comprised of a majority of independent directors has had any perceptible impact on funds.
3 The tendency to treat all members of a group as above average, particularly with respect to numerical values such as test scores or executive salaries; in a survey; the tendency for most people to describe themselves or their abilities as above average.
4 Section 48 (Violation of Title): "Procurement. It shall be unlawful for any person, directly or indirectly, to cause to be done any act or thing through or by means of any other person which it would be unlawful for such person to do under the provisions of this title or any rule, regulation, or order thereunder." (emphasis added)
5 Another reason to focus on enforcement instead of rulemaking is that the latter imposes unnecessary costs on ethical fund managers.