Seifert &


Vander Weide












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FACSIMILE (612) 339-3372


January 26, 2000

Jonathan G. Katz, Secretary
Securities and Exchange Commission
450 5th Street, N.W.
Washington, DC 20549-0609

Re: File No. S7-23-99 - Role of Independent Directors of Investment Companies

Dear Mr. Katz:

I am an attorney who has practiced in the securities area since 1970. From 1970 to 1976 I was an enforcement attorney and branch chief in the Commission's Washington Regional Office. I developed, tried and argued to the Commission the first SEC enforcement action against Steadman Security Corp. My private practice has been concentrated in corporate and securities matters, including both transactions, regulatory matters and litigation. I have represented both plaintiffs and defendants (including issuers and brokers) in class and individual actions and arbitrations. I was/am one of two lead counsel for the class in Rodney v. Piper Capital Management, Inc. and Rodney v. KPMG (two cases arising from the loss incurred in 1994 by the Piper Jaffray Institutional Government Income Portfolio resulting from its use of mortgage-backed derivative securities and mortgage dollar rolls). I have advised publicly held companies and registered investment advisers.

The proposed rule is an important step in increasing investor protection through more effective fund governance. Mutual funds have been largely free of the kinds of conduct and events that have been the subject of litigation under the securities laws. In order to maintain investor confidence in U.S. capital markets, it is essential that mutual funds continue to maintain the highest possible standards of integrity in the manner in which they manage shareholders' monies.

Investors in U.S. capital markets must look for their protection to federal and state laws requiring disclosure and state corporate statutes. Over the last two decades, many state corporate statutes have reduced the scope of directors' liability. Since the mid-1970s and culminating in the Private Securities Law Reform Act of 1995, investor protection under the federal securities has been steadily shrinking. As pleading standards have been made tougher, the time for bringing such actions has shortened, and joint and several liability has been in most cases effectively eliminated. Most individual claims against brokers are shut out of the courts altogether and are subject instead to the vagaries of the arbitration system with no effective review of the arbitrators' decision. Finally, state securities statutes are often not a factor in class actions because of the difficulty in some jurisdictions of certifying state law claims in a nationwide class. If investors were to take these developments into account (which, of course, they do not), they would have to conclude that investing directly in the markets by buying and selling individual securities is far less protected than investing indirectly in such securities through mutual funds. Given the minimal ability to recover on a class basis losses incurred through deceptive conduct, it would seem that the average individual investor should invest solely through mutual funds. Besides the protection afforded by diversification, his legal protection under both the Investment Company Act of 1940 and, for open-end funds, § 11 of the Securities Act of 1933 is significantly greater than it is under Rule 10b-5 when investing directly in the market.

Notwithstanding the rhetoric that auditors and independent directors are "watchdogs," experienced practitioners know that holding auditors and directors legally accountable in civil actions for money damages is an exceedingly challenging task. Accordingly, the fundamental structures must be buttressed so that the much publicized investor protection is in fact a reality. To do less is to jeopardize investor confidence in our capital markets.

Comments regarding independent counsel

My experience leads me to agree with the ICI Advisory Group Report that independent counsel can be very helpful in ensuring that independent directors ask pertinent questions. Directors, in my experience, are too often unable or unwilling to ask the hard questions. Obviously, ostensibly independent directors should not be unwilling to do so. However, it is often the case that directors do not know enough to ask the pertinent questions.

Moreover, the normal interpersonal dynamics must be acknowledged. It is not enough to ensure that fund directors are nominally independent; measures must be implemented to make them effective. Most people wish to avoid conflict. Therefore, no matter how many rules may be adopted in an effort to achieve the selection of directors who see their unconditional loyalty as being to the shareholders, it requires a certain mindset and willingness to engage in an adversary relationship, or a relationship infused with a healthy skepticism and continuous inquiry, to make that loyalty reality. Simple human dynamics means that it is easier for a director to relate to persons in the boardroom around the table who that director has come to know, even though those persons may have differing interests from those of the shareholders the director represents, than the anonymous shareholders who the director does not know and has never met. It does require a keen understanding of fiduciary responsibility and the manner, and myriad ways, in which such responsibility manifests itself. Independent counsel can help independent directors realize their potential.

In my view, the Exemptive Rules should be amended to require independent directors of funds relying on such those rules to engage independent counsel. Indeed, in my view, the proposed rule should be made mandatory for all registered investment companies. I understand that the statutory authority of the Commission to do so may not exist. Nevertheless, I would urge the Commission to reexamine this issue or to seek legislation to enable the Commission to do so. Alternatively, the Commission may wish to consider requiring the independent directors of registered investment companies to comment in the fund's disclosure documents regarding whether they have engaged independent counsel and, if not, to disclose their reasons for not engaging independent counsel in light of the view of the Investment Company Institute that independent counsel is a "best practice."

I do not view cost as a relevant consideration in view of the benefit to fund shareholders. Assuming $15,000 as the annual cost of such counsel (50 hours at $300 per hour), the expense to a small $200 million fund would be 0.0075 percent of assets. I share the view that conflicts of the type addressed by the proposed rule go to the heart of the counsel-client relationship and should not be waivable. Accordingly, to the extent that cost is given as a reason for not engaging independent counsel, the Commission may wish to consider including in the above-suggested disclosures the estimated annual cost in both dollar and percentage terms and a comparison of such cost with the fund's expense ratio. A fund organization too small to afford such an expense may perhaps be too small period, and perhaps appropriate disclosures should be required. The Steadman organization in recent years is a prime example of the adverse effect expenses have on small funds.

Regarding what types of service providers should be included in the management organizations, I would suggest consideration be given to whether and to what extent custodians and pricing services should be so included. In many cases custodians may be included among fund "administrator" because they perform certain accounting and bookkeeping functions. If they are not, they should be. Pricing services should be included among management organizations because they are performing a function for which the fund's adviser is primarily responsible. This is a function, particularly with respect to bond funds, that should be subject to the special oversight and scrutiny of independent directors and their independent counsel. While the AICPA investment company audit guide provides that auditors examine how pricing services price the client's securities, including the methodology used, it is my understanding that as a matter of practice auditors do not do so. I would also include affiliated persons of fund advisers (including sub-advisers) and of principal underwriters (where affiliated with the fund) within "management organizations."

In my view, the potential for being adversely influenced as a result of representation of affiliated persons of fund administrators and, if included, pricing services is too attenuated to merit inclusion of such persons as management organizations. However, independent directors may wish to examine all such relationships and obtain from the independent counsel under consideration their views as to whether they believe that their advice to the independent directors could be adversely influenced by any such relationships. Any engagement by independent directors of independent counsel under the exception to the general rule and the reasons therefor should be disclosed in the fund's next annual proxy statement and the fund's statement of additional information.

With respect to what constitutes being "independent of fund management organizations," I propose that consideration be given to excepting any representation in matters involving third parties in which the primary pecuniary interest in the matter was that of the management organization's clients or funds. For example, I have represented a registered investment adviser in matters that involve the interests of its clients or managed funds. Although on one occasion I was engaged directly by the clients, on all occasions the adviser paid the legal fees. Where the same issue affects a number of funds and separately managed individual accounts, representing the adviser in its fiduciary capacity may be more efficient than engaging in multiple separate representations. While § 270.0-1(a)(6)(i)(B) allows the board to make such a determination, I would suggest that including such a specific exception would be helpful to the directors who must make such determinations. If you do not think it appropriate to modify the proposed rule to make such an exception, perhaps you might consider including in the commentary in the adopting release such representation as an example of the kinds of representation of management organizations that may come within the exception.

Not addressed is the extent to which counsel who regularly represents management organizations may be sufficiently independent to advise independent directors of a fund whose adviser such counsel does not represent. May such counsel be reluctant as independent counsel to advise the independent directors in a manner that such counsel has reason to believe would be contrary to the interests of such counsel's investment adviser clients if faced with the same issue?

Much, if not all, of the ICA expertise in the private bar lies with attorneys who regularly represent investment advisers and their funds. The Commission notes that "[a] person acting as both fund counsel and independent director counsel ordinarily should not have the types of conflicts of interest that would diminish the counsel's ability to provide zealous representation of independent directors." In my view, while the fund is clearly a separate legal entity and therefore an entity with interests separate from the adviser, because the fund has no separate operating capability, as a practical matter from an operating standpoint the interests are aligned. Thus, for much of what counsel for the fund does, the interests of the fund and the adviser and other management organizations are aligned. Accordingly, I agree with Professor Coffee that the separate interests of the fund can be better represented by counsel who is not concerned with these operating matters. However, I would also suggest that this issue might be moot in view of the practical business considerations with which present fund counsel will be confronted assuming adoption of this proposed rule. When faced with choosing between serving as independent counsel to the fund's independent directors and counsel for the management organizations, it is likely that fund counsel will elect to retain the existing relationship with the adviser.

Related to the issue of independent counsel's allegiance is the latitude that independent directors and their counsel may believe they have as a practical matter. Given the highly regulated state of the mutual fund industry, there is substantial uniformity among fund customs and practices. As to matters as to which the Commission has not provided guidance, there may be a marked reluctance to deviate from standard practice. For example, there has been a fair amount written in the media about open-end funds that continue to charge 12b-1 fees even though the funds have been closed to new investors. However, because the practice appears to be widespread, an individual fund's independent directors and their independent counsel may be reluctant to raise the issue. In the same vein is the apparent stickiness of expense ratios. Again a fair amount has been written about expense ratios remaining constant even though assets under management have substantially increased, which increase presumably ought to result in lower expense ratios as economies of scale are achieved. If independent directors and their counsel are expected to challenge standard practices that have benefited management organizations, they should be completely free of any allegiances to management organizations.

The scope of the role of the independent counsel and the limits thereon need to be considered. While this will vary based on the persons involved, there is the very real possibility that the independent counsel may become a "super director." The independent counsel is likely to be more knowledgeable about certain matters than the independent directors. The concern arises that the independent directors may unduly rely upon the independent counsel to bring matters to their attention. Likewise, the presence of independent counsel may be viewed by advisers and interested directors as diminishing their need to bring matters to the board's attention. The Commission may wish to include language in the adopting release to the effect that the presence of such counsel should in no way reduce the vigilance of all directors and officers or the scope and nature of their fiduciary duties and responsibilities. I have seen on two recent occasions where the respondent in a Commission administrative proceeding and defendant in a civil action, both of which involved registered investment companies, pointed to the panoply of directors, service providers, professional advisers, and regulators as sharing the responsibility for what happened to the fund or as evidence that certain alleged wrongdoing did not occur because not addressed by the regulators. Assuming adoption of the proposed rule, defendants and respondents will be able to add the independent counsel. It is axiomatic that when many are responsible, no one is responsible.

As noted in the preceding paragraph, the engagement of independent counsel may lead affiliated and interested persons to deem themselves less compelled to be as forthcoming with the fund's directors as they may have been. Care should be taken that, notwithstanding the apparent conflicting interests between the fund and its management organization in some areas, a not overly adversarial relationship be introduced. Fund shareholders are dependent upon the "outside" adviser for the management of their fund. It would be a disservice to fund shareholders if their management came to view the independent directors and their counsel as adversaries. While in the past fund advisers often viewed funds as their creatures and may have even viewed such funds as captive to their interests, the pendulum should not swing so far in the other direction that fund managements become wary of the fund's board of directors. Nevertheless, it seems readily apparent that the engagement of independent counsel will, if such counsel is effective, necessarily introduce into the fund-adviser relationship in many instances an element of real conflict where none may have previously existed.

To the extent that the independent counsel becomes the "eyes and ears" of the independent directors, such counsel will necessarily interact with the fund's auditors. Until recently, auditors were required, as one of their "principal audit objectives," to obtain reasonable assurance that the fund was complying with its restrictions under its stated investment objectives and policies. The Commission has apparently acquiesced to the proposed draft (September 1998) of the AICPA investment company audit guide that removes compliance with investment restrictions as a "principal audit objective." See letter to Robert Burns, Chief Counsel, Office of Chief Accountant, dated November 4, 1998, a copy of which is attached hereto. Is it contemplated that the independent counsel will be responsible for such determinations? The reference to "other compliance issues" would seem to suggest that the independent counsel is to play such a role. If so, will the presence of such counsel be deemed a mitigating factor as to the responsibilities of others who also have such a responsibility? Should, and, if so, to what extent, the independent counsel interact directly with Commission staff examiners?

Among the matters as to which independent counsel should be able to advise independent directors is whether the fund may have a claim, and, if so, whether to bring such a claim, when the fund has suffered a loss on a portfolio security. Congress, in PSLRA, sought to involve institutional investors in litigation seeking recovery for violations of the disclosure requirements of the federal securities laws. Whether PSLRA has been successful in this regard, and whether such involvement significantly increases recoveries, seem still to be unanswered questions. In this regard, the question arises whether such investors, including mutual funds, should avoid bringing claims under Rule 10b-5 and instead bring their claims under § 18 of the Securities Exchange Act of 1934. Given the paltry recoveries noted above (which are typically Rule 10b-5 actions), and assuming that the low recoveries reflect the inherent difficulty in proving such claims, it would seem that institutional investors should consider whether, as fiduciaries responsible for other people's money, they are obliged to bring their claims under § 18 where scienter is not an element. Presumably, the typical fund adviser can easily prove the requisite reliance and, therefore, has no need for the constructive reliance that Rule 10b-5 gives to those who cannot prove they actually read or otherwise personally relied upon the disclosures in question.

When faced with consideration of whether to bring a claim over an investment that a fund may have been fraudulently induced to purchase, a portfolio manager might well prefer not to do so. Aside from wanting to forget one's mistakes, the prospect of litigation is not pleasant for most persons to contemplate. The distraction of depositions and other activities related to such litigation are often enough to discourage a portfolio manager or investment adviser from initiating such litigation. However, these legitimate concerns must be balanced against the fiduciary duty owed to fund shareholders and the salutary public purpose of not allowing fraudulent conduct to go unremedied. The Commission has long recognized the important role that private civil litigation under the securities laws plays in the enforcement of the federal securities laws. Encouraging greater participation in such litigation by institutional investors, as Congress sought to do through PSLRA, should increase the effectiveness of private enforcement of the federal securities laws. Independent directors advised by independent counsel are likely to be more objective than the portfolio manager in deciding whether to participate in such actions and what claims to bring.

Comments regarding independent directors

I endorse the proposal that at least two-thirds of directors of the funds to which the rule applies be independent directors. Again, I would urge consideration of making this requirement applicable to all registered investment companies. Likewise, funds that do not have a "super-majority" of independent directors should disclose the ICI position that such a majority is a "best practice" and the reasons they do not comply. Such a majority makes sense for practical reasons. If it is deemed important that independent directors dominate the fund's board of directors, then a two-thirds majority ensures that at any one meeting there will be such dominance, given the usual absences and vacancies that unavoidably occur from time to time.

I would not endorse a 100 percent requirement. I believe that the interests of both the fund's shareholders and the adviser in the governance of the fund are such that the adviser should likewise be represented on the fund's board of directors. Moreover, maintaining interested directors on the fund's board of directors, while reminding them of their fiduciary duty to the fund's shareholders, reinforces the adviser's duty to deal fairly and candidly with the fund. Precluding all adviser representation on the fund's board of directors may engender an overly adversarial relationship that may inhibit the free flow of information needed by the fund's independent directors.

With respect to super-majority provisions in a fund's constituent documents, it seems clear that if independent directors are to be dominant, they must also be controlling. Thus, consideration should be given to stating the requirement as at least two-thirds or such higher fraction as is necessary under the fund's constituent documents to enable the independent directors, acting together, to act on any matter subject to board action. Given the thrust of the entire proposed rule, an adviser should not have veto power over an action that a super-majority of the fund's board of directors has determined to take.

The proposed transition period should be more than sufficient. Any changes that must be made in bylaws to accommodate the super-majority requirement can typically be made by the board of directors. Such changes that must be made in the fund's charter or articles of incorporation must be made by the shareholders.

Regarding the selection and nomination of independent directors, I again would propose that the requirement be made applicable to all registered investment companies or that appropriate disclosures be required where the proposed selection and nomination is not done. Under the Minnesota corporate statute, directors have wide latitude in delegating matters to committees of the board.

Ratification of independent public accountant

I endorse the proposed conditions for exempting the selection of the fund's auditors from the requirement that such selection be ratified by the fund's shareholders. I also believe that the charter should set forth specific responsibilities and methods of operation. Care must be taken that this does not become mere boilerplate. SEC examiners should review the extent to which the audit committee's performance adheres to the charter. A copy of the audit committee charter should be an exhibit to the fund's registration statement, and its provisions should be summarized in the fund's prospectus or statement of additional information. While I do not believe that such disclosures will have any effect on investment decisions, the disclosure thereof will have a salutary prophylactic effect on the independent directors and fund governance generally. Annual review of the charter would serve at least two purposes: a reminder of the nature of the obligations of the committee and an opportunity to update and expand the charter based on experience.

The charter should remain workable and easily amendable. For this reason, it should not be included in the fund's articles of incorporation, the amendment of which requires shareholder approval. Including such a charter in the bylaws would be appropriate, since the bylaws typically contain provisions dealing with the operation of the board of directors and are amendable by the board of directors.

In this regard, I would raise two other issues. Item 7 of § 240.14a-101 Schedule A, relating to information required in proxy statements, requires the registrant to state whether or not it has standing audit, nominating and compensation committees of the board of directors. I would suggest that consideration be given to including in this disclosure whether the fund's board of directors has an investment committee. Although the functions of audit and investment committees might overlap, it would seem that a committee that is responsible for reviewing in detail the manner in which the fund is managed, securities selected, and methodologies used would provide additional protection to the fund's shareholders. Other corporations do not have a similar need. If it is found that such a function should be performed by the audit committee, the audit committee should perhaps be renamed to reflect more precisely this function. Oversight of the fund's compliance with its investment objective, policies and restrictions should also be assigned to that committee.

The investment committee would also address appropriate risk measures and their disclosure; in particular, such a committee might consider the extent to which verbal risk disclosures in prospectuses and other disclosure documents are consistent with standard numerical risk measures. In my view, the Commission has not shown sufficient leadership in the area of risk measurement. Mutual funds are permitted to show performance with graphics and numbers. Statisticians and others say that historic risk is a better predictor of future risk than historic performance is of future performance. Studies I have seen indicate that the average investor is risk averse, that his fear of losing what he has outweighs the desire to make a huge profit. Yet the emphasis in sales materials and in annual and semi-annual reports is on performance. While risk is described in boring terms that are often difficult to understand in prospectuses, performance is depicted in colorful charts and graphs. The required disclaimer that past performance does not predict future performance is in small type hardly visible in many fund publications.

This is especially troublesome in view of the misleading (in my view) nature of some fund advertising. The loosening of the rules relating to fund advertising has led to the predictable result. These should be matters that independent directors address through a committee. The current bull market may be reducing the risk averse attitude of many investors. It is at just such a time as this that the Commission and independent directors need to be especially vigilant as to what funds say to attract assets. Among all the conflicts that exist between the fund and its adviser, perhaps the most basic and certainly continuing conflict is the extent to which a fund's growth in assets under management, which is generally in the adviser's interest, has reached a point at which it may no longer be in the interests of the fund's shareholders, particularly if, as noted above, resulting economies of scale are not passed on to the fund in a lower expense ratio.

The second issue relates to the number of funds for which the board of directors in large fund organizations is responsible. I understand that it is not uncommon for audit committees consisting of perhaps four persons to meet twice a year for perhaps 45 minutes to an hour and a half each time and be responsible for as many as 30 or more different funds. This would appear to me to be a weakness in fund governance that needs to be addressed. A separate investment committee would increase the incidence of fund oversight. Alternatively, a combined investment and audit committee that met more frequently and for longer periods of time would likewise increase needed fund oversight by the independent directors. At a minimum, Commission fund examinations might include, if they presently do not, the frequency and length of meetings of such committees. Simply disclosing the number of funds or portfolios for which fund directors are responsible is not sufficient. Investors do not pick funds on the basis of the apparent adequacy of director oversight, or the apparent lack thereof.

In addition to certifying its independence, I suggest consideration be given to providing a checklist of subjects on which auditors would be required to expressly comment. Included on such a list would be valuation issues relating to securities for which market quotations are not readily available, compliance by the fund with its investment objective, policies and restrictions, any unusual or difficult accounting or audit issues encountered in the audit, and adequacy of the adviser's staff, among other matters. The committee may wish to consider requesting pertinent memoranda developed in the course of the audit (e.g., planning, analytical, completion, and valuation). The auditor should comment on each item, describing the audit work done to obtain the requisite assurance as to such matters. The audit committee should also inquire into the specific experience of the audit staff. Auditors should be encouraged to be more forthcoming with committees of the fund's board of directors. Finally, the audit committee should have a clear understanding of the precise scope of the audit, including what is covered and what is not.

Qualification as an Independent Director - ownership of adviser's securities

I propose consideration be given to whether ownership of shares in any open-end registered investment company should be included in the proposed exemption if the value of securities issued by the adviser or underwriter (or controlling person) does not exceed two or three percent of that fund's portfolio or, alternatively, if such position is not among the top ten holdings of the fund. It seems to me that, for purposes of the rule and the exclusion therefrom, there is little difference between index funds and other diversified management investment companies. For purposes of the rule, it seems that how the fund came to select the security is less important than the materiality of the director's indirect interest in that security.

Disclosure of Information about Directors

I propose that consideration be given to requiring the disclosure of the length (in addition to the currently disclosed number) of committee and board meetings and the average amount of time spent in preparation therefor. Additional information might include whether and the extent to which a board of directors of a fund organization consisting of multiple funds reviews individual funds (including, inter alia, the extent to which the fund's portfolio complies with its disclosed investment objective, policies, strategies and restrictions) and the frequency of such reviews. This and the proposed disclosures should be included in the prospectus because that is the only document the investor is supposed to receive contemporaneously with his or her investment. Has the Commission ever sought to determine the frequency with which the SAI is requested?

With respect to the circumstances raising potential conflicts of interest that the Commission is proposing be disclosed, I believe that disclosure of directors' positions, interests, transactions and relationships is appropriate for the reasons given. Such information is less important to an individual investment decision than it is from a prophylactic standpoint, as is suggested in the release (the purpose of public dissemination that may discourage the selection of independent directors who have such conflicts). For the same reason, I suggest consideration be given to requiring the same disclosures of fund counsel. It would seem that the same concerns arise regarding the fund's counsel where the independent directors have not engaged independent counsel.

Thank you for your consideration of my comments. I hope you find them helpful.

Very truly yours,

Vernon J. Vander Weide