January 21, 2000
Chairman Arthur Levitt
Securities & Exchange Commission
450 Fifth Street
Washington, D.C. 20549
RE: Comments on New Rules and Rule Amendments Intended to Enhance
the Effectiveness of Independent Directors
Dear Chairman Levitt:
I wish to present my comments pertaining to the proposed new rules intended to enhance the effectiveness of independent directors.
By way of background, I have been in the securities industry for approximately 30 years (as a registered representative at two leading brokerage firms, a trust investment officer for 11 years at a leading U.S. Bank and finally for the last 13 years as the president and chief investment officer of an investment advisory firm that currently manages approximately $450,000,000 of assets). Approximately $300,000,000 of the $450,000,000 under management is invested in closed-end investment companies, selling at discounts to their respective net asset values. We currently file 13-D's on approximately 11 funds. The skills that we have developed, in buying and selling closed-end funds, have caused us to be ranked among the top investment managers in many categories over the last 1, 3, 5 and 10 year periods of time by "Nelson's World's Best Money Managers."
First of all, I would like to applaud you and the Commission for attempting to enhance the roll of independent directors in the governing of funds operations. However, most independent directors are not really that independent.
It is still a common practice that most independent directors are initially picked by fund management groups. Often these so-called independent directors, in reality, "house directors," generally vote with management. Many of these independent directors do not even own shares of the fund(s) which they are serving. Many proposals made by shareholders over the last several years have been in the best interest of shareholders of the fund, only to be opposed and rejected by the independent directors.
In our capacity as registered investment advisors, we have over 5% stockholder positions in over 11 different closed-end investment companies. In some closed-end funds we own as much as 17% of the outstanding shares. We have never been asked by the management group of any of the funds that we own to ever serve or be considered to serve as a director.
Additionally, one of my colleagues, Donald R. Chambers, Ph.D. Lafayette College, Walter Hanson, finance professor, has written many funds offering his services as an independent director candidate. He too has never been asked to serve as a director.
Chairman Levitt, the industry is not ready for all of the proposals currently presented. The fact is that the independent directors are really not independent in most cases. Directors have been "rubber stamping" the wishes of managements.
Empirical Evidence that Independent Directors are not Independent
In the 1956 Forbes first annual mutual fund survey, the average stock fund charged 0.8% of assets annually to cover management fees and overhead expenses. Today, even if we don't count 12b-1 distribution fees, the average stock fund's expenses are 1.2%. With the growth in the industry I guess directors have not heard about "economies of scale." Costs have risen 50% in four decades for stock funds. Where have these watchdog directors been that are supposed to "work tirelessly for the best interest of shareholders?" How have the so-called independent directors voted?"
When is the last time independent directors have "fired" the fund's management for poor performance? Don't you think that the "bottom" 25% should be fired? Trustees of pension and profit sharing plans routinely "fire" managers that fail to perform, as part of their fiduciary duty to plan participants. It would stand to reason that it is the fiduciary duty, under the 1940 Act, of the complete (independent and non-independent) board of directors to ensure the "best" performance for the owners at the fund. This should include removing managers and management groups based on performance and expenses. It is the "fiduciary duty" of the board to act for the "best interest" of the shareholders. Why hasn't the SEC taken action against some groups of directors for "fiduciary liability?"
Look at the poor performance of domestic stock funds. According to the 10-31-99 Morningstar report, the 3,953 domestic stock funds with $2,329.3 billions in assets performed as follows compared to the S&P 500:
Periods Ending 10/31/99 3 years 5 years 10 years Ave. Domestic Stock Fund 17.37% 18.64% 14.33% S and P 500 Index 26.49 25.99 17.80 Difference -9.12% -7.35% -3.47%
The talent pool has been so diminished by the growth in the number of funds in the last ten years that relative performance is horrible. Directors should be held accountable for this decrease in the quality of investment management.
If we didn't have "house" directors, we would see a large number of mergers of funds with poor management teams loosing assets to the better management teams.
If we didn't have "house" directors, industry expenses would decline instead of rising. If "directors" were held to the fiduciary standards of ERISA, the mutual fund industry would have: (1) Better performance (2) Lower expenses (3) Consolidations
Another bit of empirical evidence showing that the "so-called" independent directors are not independent is changes to articles of incorporation and by-laws that stifle shareholder rights and are approved by boards each year.
Most funds are incorporated in Maryland, Delaware or Massachusetts. If the "independent directors" were representing the interest of shareholders, they would not want the funds incorporated in these states and certainly should not approve changes to articles of incorporation and by-laws that deprive shareholders of their "rights." Yet, they do approve these changes.
Three states (Maryland, Delaware and Massachusetts) are to shareholders' rights as the Republic of China is to human rights.
We have been informed by a Fund that our candidates for The Board of Directors, because of the Fund's By-laws (that were approved by the so-called independent directors), needed 80% of the outstanding vote. Their candidates only needed a majority of a quorum present which could be as little as 25% plus to get their candidates elected (Maryland Incorporation). Is this fair? Can you imagine shareholders having to go into Maryland court over this?
The so-called independent directors who vote in favor of oppressive by-laws and oppressive articles of incorporation are not representing the interest of shareholders. They are representing the interest of management. How can they be considered independent?
The SEC in 1992 wrote a report on mutual fund regulation. The report said, "the role of directors in policing conflicts of interest is central to the laws that govern mutual funds." If this is the case than how come directors regularly side with management? In the case of IBM selling its fund business to Fleet, how could independent directors approve a deal that was clearly not in the best interest of shareholders? What about when groups "including directors" buy out dissident shareholders of closed end funds only to make the remaining shareholders more disenfranchised. No conflict? What if pension or profit sharing plan trustees under ERISA did the same thing? It is a prohibited transaction isn't it!
These people are not independent. They should not be given more powers at the expense of the shareholders. They are "house" directors working for the interest of management.
How come independent directors don't attend shareholder meetings on a regular basis? The answer is because they don't represent shareholders' interest; but they do attend meetings with management. Could you imagine in our political system a candidate that never met with voters?
Chairman Levitt, the empirical evidence that I have presented indicates that independent directors are not really independent.
I urge you not to pass these changes being proposed until a process is in place to elect truly independent directors that will "tirelessly work in the best interest of shareholders." The SEC must make it easy, fair, and equitable for shareholders to nominate and elect independent directors of their choice. Then we would have independent directors.
Management can make it difficult under state laws for shareholders to nominate directors or present proposals for a shareholder vote. They have an unfair advantage in proxy solicitations because they are not required to provide a "shareholder list" to shareholders. It is economically unjust that management can charge as much as $15.00 to mail proxy materials prepared by shareholders, whereas ADT only charges $2 to mail the same proxy materials. It is unequitable that proxy expenses for directors nominated by the existing directors of the fund are paid for out of the fund even if the directors loose, whereas shareholder proposal directors' proxy expenses are never reimbursed if they loose, even if they receive a significant vote.
Look at the letter from Donald R. Logan to Paul Roye. When is the SEC going to take action and sue directors for breach of fiduciary duties? Shareholders can't afford to bring these suits.
The proposal that I am most vehemently opposed to, is the one that would exempt funds that have independent audit committees from having to seek shareholder approval of the funds' auditor. This proposal should not be passed for the following reasons:
First, our forefathers, in creating The 1940 Act, saw the wisdom allowing shareholders to vote against an auditor that permits the wasting of shareholder assets. The 1940 Act further states that a fund must send an audited financial report to the SEC at least annually where the fund's auditor has been approved by the shareholders of the fund. If in fact an auditor is rejected, then the fund must seek to have another auditor elected, which would require not just a simple majority vote of a quorum present at a meeting; but two-thirds of a quorum present at a meeting or 50% of the outstanding shares of the fund. This tactic can be used by shareholders that are fed up with management and the so-called independent directors. It levels the playing field against oppressive by-laws and articles of incorporation. To take this right away from shareholders would essentially eliminate shareholder rights that are guaranteed under The 1940 Act.
In light of the fact that it is so difficult under state law (particularly Maryland, Delaware, and Massachusetts) for shareholders to initiate actions that they deem in their best interest, I believe the SEC should continue to have shareholders approve the auditors, even though the auditor selection is by independent directors. The standards of fiduciary duty, should be enforced and monitored, even in the context of the independent auditor. However, the auditor should be able to be removed by shareholders to insure the "best possible interest" of the shareholders. Please don't take this right away from shareholders.
I am also opposed to allowing directors to impose 12-B-1 fees on any funds unless it is contained in the original prospectus.
I am in favor of the SEC trying to level the playing field between shareholders' interest and that of the management companies interest with respect to the investment company industry. Please don't take away shareholders' rights.
George W. Karpus