United Services Automobile Association
Robert G. Davis
March 10, 2004
VIA EMAIL TRANSMISSION
United States Securities and Exchange Commission
Re: Investment Company Governance
Dear Mr. Katz:
On behalf of United Services Automobile Association (USAA), I am pleased to provide comments on the Securities and Exchange Commission's proposed rulemaking initiatives on mutual fund corporate governance. I wrote a letter dated January 12, 2004 to Chairman Donaldson and the other Commissioners expressing similar views, which was prior to the proposal of these rule amendments. This comment letter supplements that letter.
As background, the USAA Family of Funds (USAA Funds) consists of 38 no-load mutual funds. Those 38 funds are each a series of one of four legal entities: USAA Mutual Fund, Inc.; USAA Investment Trust; USAA Tax Exempt Fund, Inc.; and USAA State Tax-Free Trust. These legal entities are each governed by a board consisting of the same seven directors. Five of the seven directors for each board are independent (71%). I serve as the chair of each board. Christopher W. Claus, president and CEO of the funds' adviser, USAA Investment Management Company, also serves on each board.
We agree that vigorous enforcement by the Commission against those violating the trust of their shareholders is both necessary and justified. We urge the Commission, however, to take a measured approach in its rulemaking initiatives, and to resist adopting rules that will result in industry-wide inefficiencies in mutual fund operations to address the wrongdoings of a minority. With that in mind, USAA expresses the following positions:
Each of these points is discussed in further detail below.
We oppose the proposal to require each mutual fund board to be led by an independent chair. We believe rulemaking mandating an independent chair is neither necessary, nor appropriate, and will likely result in unintended consequences. The U.S. House of Representatives also appears to have reached the same conclusion, as reflected in its exclusion from H.R. 2420, the Mutual Funds Integrity and Fee Transparency Act passed by the House in 2003, and the House Financial Services Committee's recent decision not to include such a mandatory provision in its recent markup of other securities legislation.1
As the Commission is aware, most mutual fund boards are already comprised of a majority of independent directors as required for funds to rely upon certain SEC exemptive rules, and many fund complexes, like the USAA Funds, have a board comprised of at least 67% independent directors consistent with the Investment Company Institute's (ICI) recommendations for best governance practices. Thus, independent directors of most fund complexes, including the USAA Funds, already have the power to elect an independent chair if they so desire. In light of the existing power of independent directors to elect one of their own, we believe a rule mandating an independent chair could only be justified by the existence of a compelling reason to eliminate the board's traditional discretion to select as the chair the most qualified person that best fits the needs of the particular complex and the efficient operation of its board. We do not believe that any such compelling reason exists.
Boards are entirely familiar with their obligation to ensure that the chair is both capable and trustworthy. There is no reason to believe that the board, and the independent directors, lack that fundamental judgment capacity in the selection of the chair. Interestingly, many industry commentators are calling for the strengthening of the role of independent directors at the same time that they are calling for a mandatory independent chair. A mandatory rule that would restrict the discretion and choice of the independent directors in the selection of the chair is fundamentally inconsistent with any professed goal of strengthening their role and authority. The unspoken assumption underlying support for this proposal appears to be that the independent directors, as a group, have somehow failed in their responsibilities based on the apparent problems at some fund complexes. We disagree with that assumption. In my experience with the independent directors of the USAA Funds, independent directors take and exercise their oversight responsibilities very seriously. Independent directors have the right to determine, in the exercise of their business judgment, the best person to serve as the chair.2
Although an independent chair might make sense for some fund companies, we believe that there are sound business reasons why a board, including its independent directors, could conclude that an interested chair is better for a particular fund complex. We believe USAA's facts provide a good example. USAA is a member-owned association that seeks to facilitate the financial security of its members and their families by providing a full range of highly competitive financial products and services, including insurance, banking and investment products. USAA members are the American military community, and include present and former commissioned and noncommissioned officers, enlisted personnel, and their families. Although many of USAA's products and services, including its mutual funds, may be purchased by non-members, USAA does not actively market beyond its eligible member base and has extremely limited outside distribution arrangements to sell its mutual funds.
Certainly within USAA's overall corporate structure, and I suspect with many fund groups sponsored by diversified financial services organizations, the importance of communicating one cohesive vision of our products and services is critical and very challenging in today's environment. I consider one of my most important responsibilities relating to the USAA Funds to be communication of the role that the Funds play in our overall mission to deliver highly competitive financial products and services to our membership. Today, I can provide that link between USAA and the USAA Funds to the Funds' directors as well as the USAA membership. Mandating an independent chair will make that task more difficult. USAA members are familiar with my role at USAA from our annual report, our annual members' meeting, and a variety of other communication channels. Given our limited outside distribution arrangements and direct marketing approach, we know our mutual fund investors take the initiative to invest in the USAA Funds, and do so in part because of USAA's name and reputation for service to the military community. Thus, members traditionally want to know USAA's position on an issue as expressed by its management. USAA operates as one association, not a conglomerate of individual companies. Our communications are intended to speak with one voice. In my role as Chairman and CEO of USAA, I am the voice our members primarily hear from, and expect to hear from. Let me just share with you one example.
Although USAA's ownership structure is somewhat unique, it does point out that mandating a one-size fits all rule will not provide board members with sufficient flexibility to select the most qualified person that best fits the needs of the particular complex and the efficient operation of its board.
Such a draconian rule could perhaps be justified if there was a causal connection between an interested chair and regulatory problems. That connection does not appear to exist. At the open meeting to consider these proposals, the SEC staff admitted that there was no causal connection between an interested chair and regulatory problems, or any evidence that an independent chair will prevent these problems. For example, some of the fund complexes with alleged regulatory problems had independent chairs, and one had a completely independent board. Thus, based on prior industry history, a regulatory requirement mandating an independent chair will not ensure greater regulatory compliance. In fact, those interested chairs who serve as the Chairman and CEO of their integrated financial services companies (rather than just the advisory firm) can more effectively promote a culture of compliance at fund companies because of their direct management authority over advisory personnel, and because of their greater interest in preserving the reputation of the integrated company as a whole.
It certainly bears noting that not only is there no evidence that an independent chair prevents the regulatory issues raised of late, but a quick look at major fund firms that have to date not made headlines for regulatory issues, and that generally have lower than average fund expense ratios, argues against mandating an independent chair. We believe mandating an independent chair at firms like Fidelity, T. Rowe Price, Vanguard, as well as USAA, would be counterproductive. A mandatory independent chair requirement almost certainly will increase the costs in time and money for operating a fund complex, which ultimately in turn will be passed on to fund shareholders. Given the other recent initiatives that have or will increase the operating costs of funds that at some point will be passed on to investors, we do not believe that another cost-increasing rule can or should be justified based on the possibility that it may improve the "appearance" of a perceived problem of which fund shareholders have not complained. This is particularly true in light of the fact that the identity of a board chair (and whether he or she is independent or interested) is disclosed in a fund's annual report that is sent to shareholders (and available in the fund's statement of additional information). Investors who want to invest in funds with only independent chairs have easy access to this information and can invest their monies accordingly. In the absence of proof that such a requirement will remedy regulatory problems or another identified problem, we believe mandating an independent chair would be elevating an academic approach over practical realities.
Alternatives to an Independent Chair
In the proposing release, the Commission also asked for alternatives to a mandatory independent chair. The Commission noted in the release that the chair can largely control the agenda, which could include matters not welcome by the investment adviser. The Commission also notes that the chair can dominate the fund boardroom's culture, which in turn can foster or suppress meaningful dialogue. We submit that there are other ways to encourage the input of independent directors to the contents of the agenda and to foster meaningful dialogue. Initially, the Commission's proposed requirement that the independent directors meet quarterly in separate session will foster meaningful dialogue among the independent directors without management present. We note that the USAA Funds' independent directors, similar to some other fund groups, already meet separately with their independent counsel the day before board and committee meetings to discuss items without management or the interested directors present. We believe this is a sound corporate governance practice.
There are different ways that the Commission could encourage and facilitate the ability of the independent directors to have a voice in setting the agenda for fund board meetings. For example, the ICI Advisory Group also recommended in 1999 that fund boards designate a "lead" independent director to act as a liaison between management and the other independent directors.3 We would support such a provision if the independent directors determine that such a structure works best for them. We also believe mutual fund boards should, to the extent they have not done so, establish a committee devoted to corporate governance matters. This committee should be chaired by the "lead" independent director. We also believe the chair of a mutual fund's audit committee should be an independent director. The USAA Funds' boards have audit and corporate governance committees that are chaired by independent directors and comprised solely of the independent directors. The chairs of these committees act as a liaison between the independent directors and management. Because the interested directors do not attend these committee meetings without an express invitation from the committee chair, the independent directors of the USAA Funds have an opportunity to determine the agenda and meet without the interested directors.
In the proposing release, the Commission also asked for comment whether the election of the board chair should be an election requiring approval by a majority of the board of directors, and a majority of the independent directors. We would not oppose such a requirement in lieu of mandating an independent chair. An election may help ensure that the chair remains responsive to the other directors, and requiring a majority vote of the independent directors will ensure that any chair has the support of both the majority of the board and the independent directors.
Supermajority of Independent Directors
The Commission also has proposed that mutual fund boards be comprised of at least 75% independent directors. Currently, many fund boards, including the USAA Funds, have a board comprised of at least 67% independent directors as recommended by the ICI Advisory Group on governance practices in 1999. Accordingly, we would not object to a rule mandating that 67% of fund boards be comprised of independent directors. If the Commission requires a 75% minimum percentage, many fund groups, including the USAA Funds, would have to reconstitute their boards. Some of these boards could add a new director without triggering a shareholder vote, but many fund groups would be required to obtain shareholder approval, triggering the need for a proxy solicitation and the resulting cost to fund shareholders. There are no corporate matters upon which fund boards vote that require a 75% vote. The Commission should consider whether fund shareholders should be asked to bear additional costs to implement a regulation that will provide no greater protection than a 67% minimum requirement that many fund complexes implemented long before the industry scandals.
The independent directors of many fund groups, including the USAA Funds, already meet in separate session and are joined by independent counsel in those sessions. We do not object to a requirement that independent directors meet separately at least quarterly. We do not believe retention of independent counsel should be mandated, but if independent directors believe they need separate outside counsel they should be able to retain such counsel or other outside consultants to the extent they believe necessary to fulfill their duties. We would note that the USAA Funds, like many fund complexes, already retain board materials, including the information requested by, and given to, the board for its annual consideration of the advisory agreement.
In summary, we encourage the Commission to assess carefully the costs and benefits of each of its proposed rules on fund corporate governance. Most notably, USAA strongly opposes any rule that would require every mutual fund board to have an independent chair. A one-size fits all rule will fail to give a board any flexibility to select the most qualified person that best fits the needs and expectations of the particular fund complex and the efficient operation of the board. We believe that the board members, including the independent directors who already control most fund boards, are in the best position to determine the most effective chair based on the needs and expectations of the investors whose interests they serve. In the absence of a compelling reason to mandate requiring an independent chair, we believe that the Commission should leave this determination to the discretion of the board. In the alternative, we believe that the Commission should implement reasonable and functional alternative procedures or processes to facilitate and encourage meaningful dialogue among the independent directors and their ability to contribute and influence the content of board or committee agendas.
We appreciate the opportunity to provide comments on these rule proposals. If you have any questions regarding our comments, or would like additional information, please contact Mark S. Howard at (210) 498-8696.
Robert G. Davis