Merrill Lynch Asset Management
Princeton Services, Inc.
800 Scudders Mill Road
Plainsboro, New Jersey 08536
609 282 2000
P. O. Box 9011
Princeton, New Jersey 08543-9011
January 28, 2000
Jonathan G. Katz, Secretary
U.S. Securities and Exchange Commission
450 5th Street, N.W.
Washington, DC 20549
Re: Role of Independent Directors of Investment Companies
File No. S7-23-99
Dear Mr. Katz:
The Merrill Lynch Asset Management Group ("MLAMG") is comprised of Merrill Lynch Asset Management, L.P., Fund Asset Management, L.P. and Merrill Lynch Mercury Asset Management International, Ltd., all which are wholly-owned subsidiaries of Merrill Lynch & Co., Inc. (Merrill Lynch & Co., Inc., together with all of its constituent subsidiaries, are hereinafter referred to as "Merrill Lynch"). MLAMG acts as the investment adviser to over 200 registered management investment companies and has been advising investment companies in the United States for almost 25 years. We reviewed the above-referenced proposed rulemaking with great interest and would like to offer some of our views, based upon years of working successfully with independent fund directors.
As a general observation, while we support many of the practices that would be required by the proposed rulemaking, we question the need for incorporating such practices in regulation. The Commission's proposing release discusses the virtues of enhanced independent director authority, but fails to cite to specific, or even general, abuses in the mutual fund industry that would warrant increased regulation of mutual fund corporate governance. Furthermore, as indicated in an Investment Company Institute report of an Advisory Group on Best Practices for Fund Directors (the "Best Practices Report"), the overwhelming majority of mutual fund complexes already adhere to many of the practices that would be required by the proposed regulation. We therefore question the need for requiring by rule that which the industry already does and which under judicial decisions has a strong incentive to do. To the extent that the Commission nevertheless decides that further regulation in this area is warranted, we would like to express our general support for certain of the board constitution and qualification requirements, and our opposition to any requirements relating to counsel for the independent directors and increased disclosure requirements.
Board Constitution Requirements
Like the Commission, we believe that investment company board governance is best served by strong and active independent directors. As a practical matter, our funds would be little affected by much that is currently proposed, in that many of the practices that would be required already are in place with respect to the MLAMG funds. For instance, independent directors already represent not just a majority of the board of every fund we manage, but a supermajority of at least two-thirds as well. Since the early 1980s, each of these boards has had a nominating committee, consisting only of the independent directors, which selects and recommends new independent directors. Moreover, since the late 1970s the independent directors on each MLAMG fund's board have been represented by their own counsel that is separate from counsel to the manager. Clearly, we believe that the participation of strong independent directors benefits fund shareholders and our own business.
We are concerned, however, that the Commission may possess an erroneous view of the dynamic between fund management and independent directors. Certainly the Investment Company Act of 1940, as amended (the "1940 Act"), recognizes the conflicts of interest that may occur in the mutual fund industry, and in large part the 1940 Act is designed to regulate those conflicts and ameliorate their effects. Nevertheless, management's interests converge with those of the independent directors, more often than not, even if for different reasons.
From a legal standpoint, management and independent directors can both face liabilities for not serving shareholders appropriately. For instance, like the directors, management in some circumstances could be subjected to liability under Section 36(a) of the 1940 Act, for breach of fiduciary duties to a fund it manages. Further, no distinction is made in Section 36(a) between interested and non-interested directors. Under state law, all directors owe a fiduciary obligation to the corporation they serve. Again, no distinction is there made between interested and non-interested directors. Investment advisers similarly owe specific fiduciary obligations to the funds they manage pursuant to the Investment Advisers Act of 1940, as amended, and state law. From a business perspective, management's interests are best served through successful management of a fund. Such success depends in part upon give-and-take between management and the fund's independent directors. While management and the directors may come to the table representing different concerns, those concerns can be, and usually are, met in a business-like and non-confrontational way.
We note our own experience in this regard. In Gartenberg v. Merrill Lynch Asset Management, Inc.1 and Krinsk v. Fund Asset Management, Inc.2, plaintiffs accused the investment adviser of having breached its duty under Section 36(b) with respect to the compensation it received. In both cases, the courts dismissed the actions after trial having found no breach of duty under Section 36(b). Those cases describe many examples of the arms-length negotiations between management and the independent directors. Far from simply agreeing to management's proposals, the directors had at times refused to approve management's fee proposals, insisting instead on additional breakpoints as asset sizes grew. The very fact of the strong role of the independent directors thus protected us, as well as themselves, from liability.3
Because we support a strong role for independent directors, should the Commission deem it necessary to increase regulation in this area, we therefore would not oppose a requirement that independent directors constitute a majority of the board. We question the added utility of requiring a two-thirds supermajority, however, and point to certain of its impracticalities. For instance, we believe that a majority of independent directors can protect a fund just as effectively as can a supermajority. Moreover, in the event that a board vacancy results in less than a supermajority but still a majority of independent directors, a requirement of a simple majority of independent directors would provide a "cushion" while the nominating committee searches for a replacement. If the rule were to be adopted requiring a supermajority, many instances of death or resignation of an independent director would create the need for a burdensome and time-constrained process of searching for a replacement. This could create a hurried, unsatisfactory result where instead the nominating committee should be able to proceed deliberately and cautiously. In some circumstances, a vacancy could trigger a shareholder meeting and a consequent proxy solicitation, with all the expense that involves for the fund. For these reasons, we recommend that the Commission, if it decides to change board composition requirements, require only a simple majority of independent directors and increase the period in which to select a replacement to 120 days if such replacement may be selected by the board, or 240 days, if a shareholder meeting is required.
In addition, we note that Section 16 of the 1940 Act requires that two-thirds of the board be elected directly by shareholders. It does not require that two-thirds of the board be independent. Instead, Section 10 of the 1940 Act provides that only 40% of the board be independent. We believe that Section 16 provides for shareholder election of a supermajority of the directors, regardless of interest, as a protection against domination by management. If the Commission believes that a supermajority of independent directors would better serve fund shareholders, perhaps instead of imposing that requirement directly, it could instead provide that where a supermajority of independent directors exists, shareholder election of less than two-thirds of the board would be sufficient. This solution would serve as an incentive for funds that do not have a supermajority of independent directors to increase the percentage to a supermajority, while at the same time obviating the need for funds to undertake the expense of a proxy solicitation.
We further request that the Commission clarify in any release adopting the proposed rules that, while the selection of independent directors ought to be left to a nominating committee comprised of independent directors, selection of directors need not be done in isolation of fund management. Management might have legitimate business concerns that it should be permitted to express. In some cases these concerns may be critical to management's business. For instance, because of the need for directors to have full information about the funds they serve, including proprietary information belonging to management, the appointment of an individual who is associated with a direct competitor of management may prove to be impractical.
As mentioned previously, all of the independent directors who participate on boards of funds we manage are represented by legal counsel that is separate from counsel for management. Consistent with our belief that disinterested directors should be genuinely independent, we believe such directors benefit from the wisdom and protection offered by counsel who is both independent and qualified. This practice also satisfies the recommendation of the Best Practices Report.
Inherent throughout the proposed regulation is the Commission's articulation that the independent directors are capable of protecting the funds they serve and the shareholders who invest in them. Further, such articulation is consistent with the pattern of regulatory development by the Commission over the last 20 years in which directors increasingly have been entrusted with the responsibility for monitoring against conflicts. The proposed requirement concerning the selection of independent counsel however suggests implicitly that while the Commission trusts the independent directors to protect shareholders, the Commission does not trust those same directors to protect themselves. We do not believe that the Commission intended to suggest that directors who are capable of approving investment advisory and distribution arrangements and monitoring for conflicts in principal transactions pursuant to exemptive rules or orders are incapable of selecting their own counsel. An unintended consequence of the proposed requirement nonetheless would be the substitution of the Commission's judgment, rather than that of the independent directors, as to who is qualified to represent them.
While the Commission states that the proposed regulation would require independent directors to employ counsel that is both independent and qualified, we are also concerned that the practical effects of the proposed rule would result in the selection of counsel that is independent, but not necessarily the best qualified. Many mutual funds are advised by very large global financial services firms which are engaged, directly or through affiliates, in various types of businesses. For instance, Merrill Lynch is composed of different business units that provide, among other things, asset management, brokerage services, investment banking, insurance, retirement services and trust company services. Moreover, Merrill Lynch has offices throughout the world. Merrill Lynch hires law firms not just to represent it in "financial services" transactions, such as nation-wide underwritings, but also for a variety of other services, such as litigation, real estate transactions, employment, trademark and banking. There are even instances in which the selection of counsel by Merrill Lynch is from a pool of firms recommended by the issuer. This happens, from time to time, where a municipal issuer recommends counsel to represent the underwriter. A variety of intricacies borne out of Merrill Lynch's business reach can further create situations complicating legal representation. Examples of these can be found where Merrill Lynch acts not as fund adviser, but as sub-adviser to outside mutual funds, or where an affiliated business unit provides third-party administrative services to funds not managed by MLAMG. Due to increasing consolidation within the financial services industries, these circumstances are hardly unusual.
Within the legal profession, globalization and consolidation have also been occurring. The increased complexity of the financial services industries additionally means that greater sophistication of counsel is required. Such services increasingly are supplied by large law firms that can provide the sophistication and support necessary in the representation of large global financial services firms. Greater specialization of practice areas within law firms also has developed. A legal specialist within a firm often has no or minimal business dealings with another legal specialist within the same law firm. Such attorneys may not even work in the same geographic location. Because of these trends, we believe that an attorney who is familiar with investment management matters likely would be a member of a firm providing a variety of legal services to the financial community. There is a significant likelihood that a law firm with a practice of this type also represents a Merrill Lynch affiliate in a matter that may or may not be related to MLAMG business. The consequence of the proposed rule therefore could force many boards to seek representation from attorneys who do not normally represent clients in the financial services industry. While those attorneys may satisfy the independence criteria, they may lack the specialized expertise and industry experience that could be of most benefit to the directors.
The proposed rule would therefore result in a shrinking pool of available qualified attorneys due to present conflicts. It would moreover hasten this phenomenon out of fear of future conflicts. Some law firms might be unwilling to represent independent directors if it meant being foreclosed from undertaking in the future a legal representation with respect to a matter that was entirely unrelated to investment companies.
We also wish to underscore what we believe to be a largely personal relationship between counsel and the independent directors. Typically, independent directors hire an individual lawyer, not an entire law firm, to advise them. The directors' duties generally call for decision-making. Counsel generally participates with the independent directors in their discussions, and evaluates the information provided together with them. Personal chemistry and shared history are more important to the directors in this context than a business relationship with a firm. It is at this point that a familiar individual whom the independent directors trust provides effective representation.
Further, we believe that the solutions to potential conflict situations involving independent directors currently exist. First, we note that the legal profession currently prevents lawyers from undertaking representation in the event of unresolvable conflicts. State bar associations are perhaps best able to determine which conflicts present impermissible representation and which do not. Legal ethical requirements further provide that, once a lawyer undertakes a representation, that lawyer act unswervingly in the client's interest. We therefore are satisfied that an attorney would first determine whether he or she could represent the independent directors without personal bias, and if so, then zealously guard the directors' interests. Second, as mentioned above, we believe that the independent directors themselves are most qualified to determine whether legal counsel is both sufficiently qualified and independent. Relying upon the independent directors to establish criteria for counsel and evaluate counsel against such criteria would be consistent with the present rulemaking initiative. We therefore recommend that the Commission abandon the proposed rulemaking with respect to counsel for the independent directors.
The proposed rule amendments would not require any new or additional disclosure about a fund's investment adviser. It furthermore may not result in disclosure of any meaningful information about the directors.4 Because of our close involvement with the directors, we nevertheless wish to offer our views on this subject.
We question the utility of the proposal. The Commission's disclosure policy generally rests on the concept of materiality.5 In an offering document, such as a prospectus or a statement of additional information, materiality depends upon whether an investor would likely be influenced by the information in deciding whether to invest. In a proxy statement, material information would be that on which a shareholder would base a decision in whole or in part, of how to vote a proposal. Arguably, information relating to a director's potential conflicts of interest could be meaningful where shareholders are asked to elect the director. We do not believe, however, that an investor decides whether to invest in a fund based on the information proposed to be disclosed in the Commission's rulemaking. Such information would only serve to confuse investors by suggesting that certain independent directors may be less independent than others. We also believe that such disclosure would be contrary to the Commission's recent policy disfavoring the inclusion of unnecessary details in disclosure documents.6
We suggest that the Commission not confuse disclosure issues with the regulatory nature of the 1940 Act fund governance provisions. We suspect that the real concern behind the proposed disclosure requirements is that of compliance with regulatory requirements. By obligating the disclosure of information about the directors' potential conflicts of interest, those conflicts either are less likely to appear or the Commission would have greater ability in determining whether, pursuant to Section 2(a)(19)(A)(vi), an order should issue designating a director as interested due to a material business or professional relationship. If, in fact, the Commission's primary concern is with the enforcement of compliance with governance requirements, we believe a better alternative would be the maintenance by the fund of information about the directors that could be updated annually, and which would be available to the Commission's staff when they inspect the fund.
The proposed amendments requiring disclosure with respect to positions, interests, transactions and relationships of directors and their immediate family members are particularly burdensome to the directors. The Commission's proposed definition of "immediate family" is overbroad in this context, and presupposes intrafamilial situations that very well may not occur. Such a requirement therefore would impose a due diligence obligation on a director beyond his or her ability to fulfill. We understand, for instance, based on conversations with the MLAMG funds' directors, that many of the independent directors have reservations about their ability to gather the requisite information from in-laws or even siblings. We therefore are concerned that this disclosure requirement would diminish the pool of available qualified individuals who would agree to serve as fund directors. We believe that a more workable alternative would be instead to have independent directors disclose conflicts relating to their dependent household members.
We also do not favor a requirement that directors disclose the amounts they personally invest in the fund complex. Disclosing amounts invested or numbers of shares held would be unduly invasive of director privacy, even if it is of aggregate amounts across an entire fund complex. It moreover would be of little value to most sophisticated shareholders, who would be the likely readers of a statement of additional information. While we recognize the Commission's attempt in this regard to create a similarity of interests between the directors and the shareholders, we believe this effort is unnecessary due to the fiduciary duties already imposed on the directors by state and federal law. Moreover, we respectfully suggest that the Commission has failed to recognize that such similarity of interests, to the extent it is created by a director's investment in the fund, results from the investment itself - not from disclosure of the content of the investment. We agree with the Investment Company Institute's position in its Best Practices report - each fund should be required to disclose whether it has a policy requiring the directors to own shares of funds within the fund complex.7
Qualification as an Independent Director
We commend the Commission for proposing Rule 2a19-3 under the 1940 Act, which would conditionally exempt an individual from being disqualified as an independent director simply because of ownership of a security held through investment in an index fund. Ownership of shares of an investment company represents a passive form of investing. This is especially the case where the investment company is an index fund, since, once the fund's investment objectives and policies are established, a director has no influence over the selection of investments in the fund. While the 5 percent threshold afforded by the proposed rule likely would not pose an actual barrier in most instances, based on the considerations listed herein, a higher threshold would not be unwarranted. We propose that the Commission clarify in any adopting release that a director's ownership of shares of any fund that is tied to a broad-based market index does not compromise his or her status as an independent director.
The current regulatory requirements concerning investment company board governance have long served investors and the mutual fund industry well. Despite the enormous growth in such industry during the past 20 years, remarkably few serious violations have been detected by the Commission or alleged in the courts. We attribute this success largely to the current regulatory scheme providing for independent directors to monitor fund management and to provide a balance of interests. While we question the need to tinker with a scheme that has been proven to accomplish its goals, we do not oppose the Commission's efforts to incorporate into rule practices to which much of the mutual fund industry already adheres. We caution the Commission, however, against attempts to preempt its own decision-making for that of the independent directors who are capable of protecting mutual fund investors.
We thank you for allowing us to comment on the proposed rulemaking.
Terry K. Glenn
Executive Vice President
Merrill Lynch Asset Management
cc: The Honorable Arthur Levitt, Chairman
The Honorable Paul P. Carey, Commissioner
The Honorable Isaac R. Hunt, Commissioner
The Honorable Norman S. Johnson, Commissioner
The Honorable Laura S. Unger, Commissioner
Paul Roye, Director, Division of Investment Management
1 694 F.2d 923 (2d Cir. 1982), cert. denied, 461 U.S. 906 (1983).
2 875 F.2d 404 (2d Cir. 1989).
3 Id. at 412 ("The expertise of the trustees, whether they are fully informed, and the extent of care and conscientiousness with which they perform their duties are among the most important factors to be examined in evaluating the reasonableness of compensation under section 36(b). See Gartenberg I, 694 F.2d at 930.").
4 For instance, disclosure of why an interested director is interested is immaterial to investors - it only matters that he or she may be interested.
5 Registration Form Used by Open-End Management Investment Companies, Investment Company Act Release No. 23064 (March 13, 1998), 63 FR 13916.
7 Should the Commission nevertheless determine that disclosure of dollar amounts of fund complexes is vital to the protection of shareholders, we would recommend the adoption of dollar amount ranges, similar to that for certain employees of the executive branch of the federal government. Under the Ethics in Government Act of 1978, such employees must disclose their financial interests within the following ranges: None (or less than $1,001); $1,001 - $15,000; $15,001 - $50,000; $50,001 - $100,000; $100,001 - $250,000; $250,001 - $500,000; $500,001 - $1,000,000; and Over $1,000,000.