|SULLIVAN & CROMWELL|
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1701 PENNSYLVANIA AVE., N.W., WASHINGTON, D.C. 20006-5805
January 28, 2000
Mr. Jonathan G. Katz, Secretary,
Securities and Exchange Commission,
450 Fifth Street, N.W.,
Washington, D.C. 20549-0609.
Re: Role of Independent Directors of Investment Companies:
Release Nos. 33-7754; 34-42007; IC-24082 (October 14,
1999), File No. S7-23-99
We are pleased to have this opportunity to comment on the release of the Securities and Exchange Commission, soliciting public comment on new rules and rule amendments under the Investment Company Act of 1940 addressing the role of independent investment company directors.
For the reasons indicated below, we respectfully urge the Commission not to adopt the proposals and instead to continue with the exemplary performance of its oversight function. We believe the proposals are generally inadvisable, as discussed under "General Comments" below. We also believe there are three areas in particular that are especially problematic, which are discussed below under "Specific Comments". These are: (i) the inappropriateness of, and the adverse effects we foresee from, the requirement that legal counsel for most investment companies' independent directors be "independent legal counsel" as defined in the proposals; (ii) the chilling effect on the willingness of directors and candidates to serve that will arise from the requirement for disclosure of extensive financial information relating to an investment company director's (and proposed director's) "immediate family members"; and (iii) our belief that interpretive relief is more appropriate than rulemaking to prevent disqualification as an independent director due to share ownership of an index fund that holds securities of the adviser or principal underwriter of the investment company or their controlling persons.
As the Commission states in its release, the mutual fund industry has experienced tremendous growth over the last 10 years. The growth of the industry and the high regard held by the public for its products and services have benefitted from the exemplary performance by the Commission of its oversight function, which has been effective without being paternalistic or intrusive. We believe, unfortunately, that the proposed rules are both, breaking with the sound tradition established by the Commission of relying on the judgment and good sense of investment company directors in overseeing the fees and conduct of investment advisers, principal underwriters and other service providers.
Proposals Represent an Inappropriate Approach to Public Policy. The Commission proposes to implement several substantive new rules - which are effectively conduct governing rules for which the Commission lacks statutory authority - as conditions to the most widely used exemptive rules. While we leave for another forum the question of the Commission's technical authority to regulate conduct in this manner, we believe this approach is out of character with the manner in which the Commission has heretofore served as regulator of the mutual fund industry and, as discussed below, is misguided.
First, the Commission states as a basis for the new conditions that these existing rules should contain provisions designed to enhance director independence and effectiveness. Yet, most of these rules have been utilized by most investment companies for more than 20 years without widespread or even apparent adverse effects on shareholders. Second, the Commission does not identify specific instances or general concerns either of the Commission or of public commenters of the inadequacy or failure of these rules, in their current forms, to protect the interests of funds and their shareholders, or of the failure of boards of directors, or of funds' independent directors, appropriately to monitor transactions carried out in reliance on the current exemptive rules.
Implementing the proposals as new conditions to these exemptive rules is therefore an artificial and inappropriate approach to public policy that is inconsistent with the Commission's traditional and successful approach to investment company regulation.
There Is No Evidence of Problems. Not only does the Commission break tradition in proposing rule amendments without pointing to any failures under the current rules, the Commission does not advance any evidence that the proposals will address problems experienced in, or will otherwise benefit or enhance, the implementation of the current exemptive rules. In this sense, the proposals are a solution in search of a problem. For example, the Commission provides no empirical evidence to support its stated belief that a fund board having at least a majority of independent directors is better equipped to perform its responsibilities of monitoring potential conflicts of interests and protecting the fund and its shareholders than one having 40% independent directors as provided in the Act. Moreover, in light of the fact that each current rule proposed to be amended already requires the action of a majority of the independent directors, whether themselves a majority or minority of all directors, there would appear to be no additional benefit or enhanced protections that would result from the proposals.
Policy of "Alignment" Is Too Vague. The Commission also states that one purpose of the proposals is better to "align" independent directors' interests in their funds with those of fund shareholders. We believe "alignment" is a terribly vague concept on which to base significant regulatory change, ignores the already significant fiduciary duties of directors so to act under the Act and state law and is, in any event, insufficient to justify the breadth of the disclosures proposed in light of their likely adverse consequences on the available pool of investment company directors. While the "alignment" of independent directors' and shareholders' interests may have superficial appeal, it does not bear scrutiny. This is because shareholders' interests as among themselves will vary. The duty of directors is to balance the interests of all shareholders, not "align" themselves with any one shareholder interest. For example, some shareholders in the same fund may have decided that paying an advisory fee higher than average to a particular adviser is the cost of obtaining that adviser's services, while other shareholders may be shocked at the size of the fee (and dismayed possibly to have recognized it only after the investment was made). In addition, in the context of closed-end funds, directors have found a divergence between short-term and long-term shareholder interests on the issue of the market discount of fund shares to net asset value.
The Proposals Would Not Achieve Alignment. According to the Commission, its proposal to require disclosure to shareholders of fund shares owned by directors would "help shareholders evaluate whether directors' interests are aligned with their own." Leaving aside for a moment the question of what it means for directors' interests to be aligned with shareholders' interests, the Commission's proposal requires disclosure of the aggregate value of equity securities of funds in the fund complex owned beneficially and of record by each director. The Commission states that "the interests of a director who holds shares in the complex will tend to be aligned with the interests of other shareholders". To us, disclosure of ownership of the aggregate value of shares of funds in the complex is more reasonably understood as a vote of confidence in the management company, rather than an indication of alignment of interests with any particular group of shareholders. Instead, if there is any validity to the concept of "alignment" of a director's interest with that of shareholders of a particular fund, we believe it could only be possible on a fund-by-fund basis. In not proposing to require separate disclosure of a director's holdings of equity securities in the fund itself, the Commission reasons that -
||this information might have limited meaning because of the many reasons that a director could have for not holding shares of any specific fund, e.g., that its investment objective did not fill a need in the director's portfolio.|
Although we agree completely with the Commission's quoted reasoning, we arrive at a different conclusion: viz., that this information (as well as aggregated fund complex information) cannot be a reliable barometer of even the tendency of "alignment" of interests.
1. Independent Legal Counsel
The Commission's proposal that counsel to independent fund directors be "independent legal counsel" will deprive directors of access to many experienced and sophisticated legal advisers at a time when the fund business is increasing in complexity. It is also the first time the Commission has sought to substantively regulate the practice of law,1 rather than allowing state and court-supervised bar associations to set ethics requirements.
Depriving Directors of Counsel. The proposal does not take into account the reality that most investment advisers (certainly based on assets under management) are part of large, often global, multi-line financial services firms, and that most U.S. law firms having investment management practices also have multi-line financial services practices and are relatively large. The result is that there will frequently be distant representations that, while permitted, regularly disclosed under ethics rules and not adversely affecting the quality of advice given, would disqualify many firms from advising independent fund directors under the Commission's proposal. For example, Sullivan & Cromwell has been one of the leading legal advisors to the investment company industry for more than 60 years. We have acted as counsel to funds, fund managers, independent directors and fund underwriters for open-end and closed-end funds.2 Sullivan & Cromwell's financial institutions practice is not limited to the investment company industry. We act regularly for a number of the leading investment banks in the United States, Europe, Asia and Latin America. Our commercial banking clients comprise many of the leading U.S. money center and regional banks, as well as a large number of the leading non-U.S. banking organizations. In addition, the firm has long provided a full range of services to the insurance industry.
If adopted, the Commission's proposal to require that counsel to independent directors be "independent legal counsel" will prevent us from continuing as counsel to the independent directors of many funds, to our detriment, and, we believe, that of our independent director clients. According to its release, the Commission "believe[s] that independent directors of most fund groups would not be required to seek new counsel". The release does not provide any empirical evidence supporting this proposition. We do not understand the basis for this belief, because our own experience, and that of a number of other firms with substantial practices in this area with whom we regularly interact, suggests otherwise.
We also believe that the independence requirements will have a chilling effect on the willingness of other law firms with financial institutions practices to enter into the investment company area because of the limitations placed thereon by such requirements and the uncertainty created by consolidations within the financial services industry on the continuity of engagements. We doubt that any nationally recognized law firm with a substantial financial institutions practice would consider representation of independent directors to be so lucrative or rewarding that the firm would forgo the opportunity to represent large, diversified financial institutions and their affiliates in order to represent the independent directors of the registered investment companies that those institutions or their affiliates manage, administer or distribute.
Investment companies and lawyers exist in a much larger financial and legal community. We think that it is ill-advised policy effectively to deny independent directors access to counsel with broad experience in the financial services arena.
The Commission Is Regulating Lawyers. The Commission notes that its independent legal counsel proposal is "not intended to regulate the practice of law, but rather to delimit the ability of independent directors to waive certain conflicts of interest." We think that this proposal does regulate the practice of law, and we do not agree with the Commission's statement that it will not be regulating the practice of law through this proposal. The rules proposed to be amended are mandatory and not safe-harbors. As discussed below, the de minimis exception does not provide meaningful relief in the world of multi-service financial institutions and broad based law firms representing independent directors. As a result, if the proposal is adopted, independent directors will not be able to retain or continue the engagement of counsel of their choice. In our view, that is regulation of the practice of law.
There is no provision of the Act that suggests any public policy with regard to the regulation of counsel or legislative intent to impose Commission oversight in this area. We are not aware of any other federal securities law or regulation that attempts to limit the client's right to choose its own lawyers. Indeed, the Commission's release cites only a provision in the U.S. Bankruptcy Code, a provision in the Maryland state bankruptcy code, and a rule of the Bureau of Indian Affairs as examples of fiduciaries having been similarly restricted in their ability to waive conflicts. The paucity, irrelevance and different context of cited precedent is consistent with our observation above about the absence of empirical evidence of conflicts problems. We urge the Commission not to change the current successful fund regulation model by substituting its judgment for the judgment of independent directors themselves in selecting their counsel. Indeed, we believe that considerations relevant to lawyers' conflicts of interest, including disclosure and remedies for abuse, should be dealt with under the existing body of ethical standards and available disciplinary procedures.
In our experience, specific issues arise from time to time in which a conflict or potential conflict in the interests of a fund, on the one hand, and a fund service provider, on the other, have made it impossible for the lawyer to act for either side. These, however, are the rare cases, and we and many law firms engaged in financial institutions practices are sensitive to the possibility that they may occur. Our experience has been that conflicts, including the potential for litigation, between a service provider, on the one hand, and a fund and its independent directors, on the other, rarely involve subtle legal issues, but instead fairly obvious commercial issues - advisory fees, distribution fees and brokerage commissions - in respect of which independent directors are fully capable of exercising their business judgment. We believe it unnecessary and inappropriate to require counsel to be independent (as defined by the proposal) at all times merely because, on rare occasion, counsel may be precluded from acting under applicable professional ethics rules.
Large and Small Fund Groups Will Be Harmed. The independent legal counsel requirements would impact both large and small fund groups whether or not affiliated with large financial institutions. Fund groups could of course choose to forgo reliance on the exemptive rules and retain their current counsel, but this will require substantial revision to their methods of operations. For example, even if the fund group's adviser is not an affiliated person of an investment bank or broker, the group's funds are likely to have 12b-1 plans and would be unable to continue to make payments or distribution expenditures thereunder. Alternatively, the funds may choose to retain counsel to independent directors, and thereby incur the expenses of the search for new counsel as well as the "learning curve" and ongoing expenses of the new counsel selected. When applied to a comparatively small asset base, these costs may materially impact a small fund's expense ratio, without an offsetting benefit. Finally, funds under substantial pressure to curb expenses may cease to retain non-"independent" counsel to the independent directors, or may ask fund counsel that is non-"independent" to cease advising the independent directors, thereby solving the immediate compliance problem at the longer-term expense of the persons the proposal was intended to benefit.
We recognize that the Commission is proposing a de minimis exception to its definition of "independent legal counsel", viz., that independent directors be permitted to retain counsel not otherwise "independent" if they determine that the counsel's representation was "so limited that it would not adversely affect the counsel's ability to provide impartial, objective, and unbiased legal counsel to the [independent] directors." We believe, however, that this exception does not offer meaningful relief from the adverse consequences we have discussed above.3
Although the investment company industry contains hundreds or thousands of widely diverse participants, past mergers and consolidations of financial institutions have reduced the pool of widely experienced law firms that could satisfy the independence criteria in the proposal. The mergers and consolidations in the financial industry that are anticipated in the wake of the enactment of the Gramm-Leach-Bliley Act will only further reduce the pool of eligible qualified counsel. As discussed above, "delimiting" the choice of counsel to independent directors only to those whose practice is narrowly focused on investment companies is not in the best interests of fund directors and shareholders. The Commission's proposal will deprive those independent directors of funds most likely to be exposed to complex legal issues of the possibility of hiring counsel with a broad perspective on the financial services industry.
2. Disclosures Pertaining to "Immediate Family Members"
Of great long-term concern to the integrity of board governance is the availability of directors and candidates willing to serve. As discussed below, we expect that the proposed disclosure requirements will discourage able and appropriate individuals from continuing or agreeing to serve as independent directors of investment companies.
In our experience, individuals considered for investment company directorships are quite willing to provide relevant information about their background and professional and personal relationships to nominating committees or their prospective director-colleagues. These recipients of the information are fully capable of evaluating it insofar as it may be probative of the "alignment" of such individuals' interests with shareholders or, alternatively, with the management or its officers and directors. However, public disclosure of all of such relationships in our view is disproportionate to the value of such information and is unduly intrusive into the personal financial affairs of directors and prospective directors and their family members. We think as well that there are not sufficient differences between the roles and responsibilities of investment company directors and of directors of other public companies to justify the breadth and intrusiveness of the proposed disclosure requirements.
Of greatest concern is the Commission's proposal to require disclosure of the value of interests held by directors and their immediate family members in an investment adviser, principal underwriter or administrator or their respective control persons. Under the proposed definition, "immediate family member" means any spouse, parent, child, sibling, mother- or father-in-law, son- or daughter-in-law, or sister- or brother-in-law, including step and adoptive relationships. Unlike the Rule 17j-1 requirements recently amended, residence in the director's household is not required for disclosure to be triggered. As confirmed by the emotional feedback received from fund directors whom we counsel, we believe that the inclusion of siblings, parents and in-laws within the definition of "immediate family members" is inappropriate and unworkable. Because "immediate family members" are not limited to dependents or household members and the information required is not limited to shares of the investment companies on whose board(s) a director or nominee serves, the information required to be disclosed will not even be within the knowledge of the director/nominee or the investment company. We believe that few siblings or other non-dependent relatives will respond favorably or at all to inquiries of this personal financial nature.
The proposed disclosure requirements in respect of a director's and his or her immediate family members' (i) material interests in material transactions, and (ii) material relationships, with the investment company or the specified "Related Parties" are also in our view excessively broad. Although the Commission has acknowledged the need for de minimis exceptions in connection with these disclosure requirements, we believe the exceptions proposed are much too narrow to be practical.4
We believe, under the rules as proposed, that the development of reliable data gathering and information monitoring systems is likely to be impossible, and that members of a director's or proposed director's immediate family are unlikely to be willing to provide the level of personal financial information necessary to comply with the disclosure requirements. As a result, we fear not only that there will be a dwindling pool of available new directors, but that there will be a substantial number of resignations by current independent directors. This result cannot be consistent with the best interests of investment company shareholders. If the pace of mergers and consolidations of financial institutions accelerates as predicted in the wake of the enactment of the Gramm-Leach-Bliley Act, we anticipate that the scope of information required to be disclosed will be broader and the resultant intrusiveness on directors' and their immediate family members' personal lives will only be further aggravated.
Particularly in light of the scope of the definition of "immediate family members" and the breadth of the transactions and relationships required to be disclosed, we do not think that any party can reasonably be expected to take responsibility for monitoring the existence of these transactions and relationships, and determining their materiality. In light of these difficulties, it is particularly troublesome that the fund will have strict liability under Section 11 of the Securities Act of 1933 for the information included in the Statement of Additional Information when, we submit, this information has no bearing on an investment decision. Even if not material, an allegation may well survive a motion to dismiss, though, and thereby bestow negotiating leverage on a plaintiff. We have similar concerns about the liability of the fund under the Securities Exchange Act of 1934 for material misstatements and omissions in its proxy statement.
Notwithstanding our concerns about the ability of investment companies and their directors to gather and monitor the information required by the proposed rules, if the Commission determines that such information is nevertheless necessary or appropriate for the Commission's use in making determinations permitted under Section 2(a)(19) that persons otherwise not "interested persons" are "interested persons", we strongly urge the Commission to require such information in filings made only under the Act and with appropriate protections from public access geared to the reasonableness of inquiries made to solicit such information.
3. Exception for Index Fund Share Holdings
Section 2(a)(19) of the Act disqualifies a person from being considered an independent director if he or she knowingly has
any direct or indirect beneficial interest in a security issued by the fund's investment adviser or principal underwriter, or by
their controlling persons. With regard to a director's ownership of securities of an index fund that seeks to replicate a
securities market index that includes securities of the fund's adviser or principal underwriter or their controlling persons,
the Commission states in its release:
|[T]his attenuated interest in the adviser's or underwriter's securities is not the type of interest Congress intended to prohibit independent directors from owning when it adopted section 2(a)(19). An index fund's investment decision-making process is dictated by the goal of mirroring the performance of a market index, and thus is largely mechanical. Because index fund portfolios typically are spread among a large number of issuers, ownership of their shares is unlikely to have a material effect on the independent judgment of a fund director.|
If the Commission stopped there, we would be in full agreement. However, we are surprised that the Commission believes it necessary to propose Rule 2a19-3 "to resolve concerns that may have arisen about the status of independent directors who own index funds". We think the notion that a holder of an index fund has a direct or indirect "beneficial interest" in shares of any component of the index is misguided, and we do not believe that a director's ownership of interests in any index fund should be a legitimate concern when determining the director's independence. We expect that the conditions imposed in the proposed rule will be more likely viewed by a director or nominee as an additional reason not to serve as an independent director rather than as an aid to determining his or her independence.
Index investments, whether through registered investment companies or pension and benefit plans, are a fundamental part of the financial landscape and not a temporary phenomenon or investment fad. We do not believe that a "conditional rule" is the appropriate means of addressing this issue. Instead, we suggest that an interpretation to the effect of the quotation above is sufficient and appropriate. In any event, we submit that pension plans that use indexing are no less "indirect" than index funds, and therefore should be included in any rule-based or interpretive relief ultimately issued on this subject. Also, consistent with our views expressed above, we do not believe that a five percent (or any other) value limitation is appropriate, and we recommend that no such limitation be part of any interpretive relief or rule.
We believe that, in seeking to make fundamental changes in board governance that would (i) otherwise require legislative change and, at the same time, (ii) constitute a dramatic and unprecedented intrusion by a Federal regulatory agency in the functioning of boards of directors of public companies, the Commission would be proceeding on an inadvisable and unnecessary path which will limit the pool of eligible and willing investment company directors and the access of independent directors to broadly experienced securities counsel.
In particular, as discussed above, we urge that the Commission (i) reconsider the issuance of any rule that would require "independent legal counsel" to independent directors, (ii) revise its proposed director disclosure requirements with a view to substantially reducing the amount of information a director would be required to divulge, particularly in respect of his or her immediate family members (which definition should also be substantially reduced in scope), and (iii) provide broad interpretive relief rather than the narrow relief of proposed Rule 2a19-3 in respect of directors' holdings in index funds.
We would be happy to discuss further any questions that the Commission may have in respect of our comments. We ask that any questions be directed to John E. Baumgardner, Jr. (212-558-3866), John T. Bostelman (212-558-3840), Donald R. Crawshaw (212-558-4016) or Earl D. Weiner (212-558-3820) in our New York office or Paul J. McElroy (202-956-7550) in our Washington office.
Very truly yours,
SULLIVAN & CROMWELL
2 Our practice includes work in the expansion of the investment company industry, including the expanding participation of banks, where we are involved directly, through establishment of affiliated funds, and indirectly, through the acquisition of fund management companies. Currently, we are counsel to the funds or their managers or independent directors for more than 10 fund groups comprising more than 200 funds.
3 The Commission signals its intention that this exception be used only in the circumstances where the nature or extent of the conflict is extremely remote or minor, and gives the example of "a law-firm partner who represented an affiliate of the fund's adviser in a minor real estate transaction." If this is a typical situation in which to invoke the exception, we believe the exception will prove to be of little use, and rarely relied upon. Also, the exception is conditioned on the directors recording their basis for invoking the exception in the board meeting minutes, citing "all relevant factors". Under the specter of potential enforcement action for, in the Commission staff's view, insufficient or unsatisfactory reasons for invoking the exception, we anticipate that this mandatory board consideration condition will only further "chill" the use of the exception.
4 According to the release, disclosure of "routine, retail" transactions and relationships between directors or immediate family members and the fund or Related Parties is not required. The example given is that a fund need not disclose that a director holds a credit card or bank or brokerage account with a fund or Related Party, unless the director were given special treatment, such as preferred access to IPOs. We are troubled by the limited scope of the example and what it signals regarding the breadth of disclosure expected by the Commission.