Role of Independent Directors of Investment Companies

Federal RegisterJan 16, 2001

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SECURITIES AND EXCHANGE COMMISSION

17 CFR Parts 239, 240, 270 and 274

[Release Nos. 33-7932; 34-43786; IC-24816; File No. S7-23-99]

RIN 3235-AH75

Role of Independent Directors of Investment Companies

AGENCY:

Securities and Exchange Commission.

ACTION:

Final rule.

SUMMARY:

The Commission is adopting amendments to certain exemptive rules under the Investment Company Act of 1940 to require that, for investment companies that rely on those rules: independent directors constitute a majority of their board of directors; independent directors select and nominate other independent directors; and any legal counsel for the independent directors be an independent legal counsel. We also are adopting amendments to our rules and forms to improve the disclosure that investment companies provide about their directors. These amendments are designed to enhance the independence and effectiveness of boards of directors of investment companies and to better enable investors to assess the independence of those directors.

DATES:

Effective Date:

February 15, 2001, except that the rescission of § 270.2a19-1 under the Investment Company Act will become effective May 12, 2001.

Compliance Date:

Section III of this release contains information on compliance dates.

FOR FURTHER INFORMATION CONTACT:

For information regarding the Investment Company Act rule amendments, contact Jaea F. Hahn, Attorney, Martha B. Peterson, Special Counsel, or C. Hunter Jones, Assistant Director, Office of Regulatory Policy, (202) 942-0690, or regarding the disclosure amendments, contact Kimberly Browning, Attorney, Peter M. Hong, Special Counsel, or Kimberly Dopkin Rasevic, Assistant Director, Office of Disclosure Regulation, (202) 942-0721, at the Division of Investment Management, Securities and Exchange Commission, 450 5th Street, NW., Washington, DC 20549-0506.

SUPPLEMENTARY INFORMATION:

The Securities and Exchange Commission (the “Commission”) is adopting new rules 2a19-3 [17 CFR 270.2a19-3], 10e-1 [17 CFR 270.10e-1], and 32a-4 [17 CFR 270.32a-4] and amendments to rules 0-1 [17 CFR 270.0-1], 10f-3 [17 CFR 270.10f-3], 12b-1 [17 CFR 270.12b-1], 15a-4 [17 CFR 270.15a-4], 17a-7 [17 CFR 270.17a-7], 17a-8 [17 CFR 270.17a-8], 17d-1 [17 CFR 270.17d-1], 17e-1 [17 CFR 270.17e-1], 17g-1 [17 CFR 270.17g-1], 18f-3 [17 CFR 270.18f-3], 23c-3 [17 CFR 270.23c-3], 30d-1 [17 CFR 270.30d-1], 30d-2 [17 CFR 270.30d-2], and 31a-2 [17 CFR 270.31a-2] under the Investment Company Act of 1940 [15 U.S.C. 80a] (“Investment Company Act” or “Act”); amendments to Forms N-1A [17 CFR 274.11A], N-2 [17 CFR 274.11a-1], and N-3 [17 CFR 274.11b] under the Investment Company Act and the Securities Act of 1933 [15 U.S.C. 77a-aa] (“Securities Act”); and amendments to Schedule 14A [17 CFR 240.14a-101] under the Securities Exchange Act of 1934 [15 U.S.C. 78a-mm] (“Exchange Act”). The Commission also is rescinding rule 2a19-1 under the Investment Company Act [17 CFR 270.2a19-1].

Table of Contents

Executive Summary

I. Background

II. Discussion

A. Amendments to Exemptive Rules to Enhance Director Independence and Effectiveness

1. Independent Directors as a Majority of the Board

2. Selection and Nomination of Independent Directors

3. Independent Legal Counsel

B. Limits on Coverage of Directors under Joint Insurance Policies

C. Independent Audit Committees

D. Qualification as an Independent Director

1. Ownership of Index Fund Securities

2. Affiliation with a Broker-Dealer

E. Disclosure of Information about Fund Directors

1. Basic Information

2. Ownership of Equity Securities in Fund Complex

3. Conflicts of Interest

4. Board's Role in Fund Governance

5. Separate Disclosure

6. Technical and Conforming Amendments

F. Recordkeeping Regarding Director Independence

III. Effective Date; Compliance Dates

IV. Cost-Benefit Analysis

V. Effects on Efficiency, Competition and Capital Formation

VI. Paperwork Reduction Act

VII. Summary of Final Regulatory Flexibility Analysis

VIII. Statutory Authority

Text of Final Rules and Forms

Executive Summary

The Commission is adopting new rules and amendments to rules and forms to enhance the independence and effectiveness of independent directors of investment companies (“funds”). First, we are adopting amendments to require, for funds relying on certain exemptive rules, that:

• Independent directors constitute a majority of the fund's board of directors;

• Independent directors select and nominate other independent directors; and

• Any legal counsel for the fund's independent directors be an independent legal counsel.

Second, the rules and amendments:

• Prevent qualified individuals from being unnecessarily disqualified from serving as independent directors;

• Protect independent directors from the costs of legal disputes with fund management;

• Permit us to monitor the independence of directors by requiring funds to keep records of their assessments of director independence;

• Temporarily suspend the independent director minimum percentage requirements if a fund falls below a required percentage due to an independent director's death or resignation; and

• exempt funds from the requirement that shareholders ratify or reject the directors' selection of an independent public accountant, if the fund establishes an audit committee composed entirely of independent directors.

Finally, we are requiring that funds provide better information about directors, including:

• Basic information about the identity and business experience of directors;

• Fund shares owned by directors;

• Information about directors that may raise conflict of interest concerns; and

• The board's role in governing the fund.

Together, these new rules and amendments are designed to reaffirm the important role that independent directors play in protecting fund investors, strengthen their hand in dealing with fund management, reinforce their independence, and provide investors with greater information to assess the directors' independence.

I. Background

Mutual funds are organized as corporations, trusts, or limited partnerships under state laws, and thus are owned by their shareholders, beneficiaries, or partners.

Like other types of corporations, trusts, or

partnerships, a mutual fund must be operated for the benefit of its owners.

Unlike most business organizations, however, mutual funds are typically organized and operated by an investment adviser that is responsible for the day-to-day operations of the fund. In most cases, the investment adviser is separate and distinct from the fund it advises, with primary responsibility and loyalty to its own shareholders.

The “external management” of mutual funds presents inherent conflicts of interest and potential for abuses that the Investment Company Act and the Commission have addressed in different ways.

For simplicity, this release focuses on mutual funds (

i.e.,

open-end funds). The amendments we are adopting, however, apply to all management investment companies, except where noted.

See generally

James M. Storey & Thomas M. Clyde, Mutual Fund Law Handbook § 7.2 (1998); Allan S. Mostoff & Olivia P. Adler,

Organizing an Investment Company—Structural Considerations, in

The Investment Company Regulation Deskbook § 2.4 (Amy L. Goodman ed., 1997).

As a result of their extensive involvement, and the general absence of shareholder activism, investment advisers typically dominate the funds they advise.

See

Role of Independent Directors of Investment Companies, Investment Company Act Release No. 24082 (Oct. 14, 1999) [64 FR 59826 (Nov. 3, 1999)] (“Proposing Release”) at n.10 and accompanying text.

An investment adviser's shareholders often have an interest in a mutual fund that is quite different from the interests of the fund's own shareholders. For example, while fund shareholders ordinarily prefer lower fees (to achieve greater returns), shareholders of the fund's investment adviser might want to maximize profits through higher fees.

See

Proposing Release,

supra

note 3, at nn.11-25 and accompanying text, for a discussion of the comprehensive regulatory scheme established by the Act to address conflicts of interest between funds and their investment advisers.

One of the ways that the Act addresses conflicts between advisers and funds is by giving mutual fund boards of directors, and in particular the disinterested directors,

an important role in fund governance.

In relying on fund boards to represent fund investors and protect their interests, Congress avoided the more detailed regulatory provisions that characterize other regulatory schemes for collective investments.

The Commission has similarly relied extensively on independent directors in rules we have adopted that exempt funds from provisions of the Act.

We refer to directors who are not “interested persons” of the fund as “independent directors” or “disinterested directors.”

See

section 2(a)(19) of the Act [15 U.S.C. 80a-2(a)(19)](defining “interested person”).

The Investment Company Act establishes a system of “checks and balances,” and relies on independent directors to “oversee the fund's operations so as to prevent abuses of investors.” James M. Storey & Thomas M. Clyde, The Uneasy Chaperone 34 (2000). Directors also have broad responsibilities to monitor compliance with securities, corporate and other laws. Robert A. Robertson,

Board Oversight of Mutual Fund Compliance Operations,

Rev. Sec. & Comm. Reg., Oct. 24, 2000, at 1.

For example, in Japan, funds may be structured only in the form of securities investment trusts, which are primarily subject to regulation under the Securities Investment Trust Law. There is no board of directors or board of trustees, and under the Securities Investment Trust Law, a “trustor company” manages the trust assets on behalf of the beneficiaries of the trust. The Japanese Ministry of Finance approves the terms and conditions of securities investment trusts, and plays a supervisory role in the day-to-day operations of the trusts.

See

Yoshiki Shimada et al.,

Regulatory Frameworks for Pooled Investment Funds: A Comparison of Japan and the United States,

38 Va. J. Int'l L. 191 (1998).

See

Proposing Release,

supra

note 3, at nn.24-25 and accompanying text.

Millions of Americans are today invested in mutual funds, which have experienced a tremendous growth in popularity over the past twenty years.

In light of this growth, and our growing reliance on independent directors to protect fund investors, last year we undertook a review of the governance of investment companies, the role of independent directors, our rules that rely on oversight by independent directors, and the information that funds are required to provide to shareholders about their independent directors.

Approximately 82.8 million individuals in 48.4 million households in the United States invest in funds. Investment Company Institute, Mutual Fund Fact Book 41 (2000).

We held a Roundtable discussion at which independent directors, investor advocates, executives of fund advisers, academics, and experienced legal counsel offered a variety of perspectives and suggestions.

After evaluating the ideas and suggestions offered by Roundtable participants last year, we proposed a package of rule and form amendments that were designed to reaffirm the important role that independent directors play in protecting fund investors, strengthen their hand in dealing with fund management, reinforce their independence, and provide investors with better information to assess the independence of directors.

See

SEC, Notice of Sunshine Act Meetings (Feb. 18, 1999) [64 FR 8632 (Feb. 22, 1999)];

see also

ABA Comm. on Ethics and Professional Responsibility, Formal Op. 93-372 (1993) (a client's generic waiver of future conflicts would be invalid if the circumstances of a representation change so that the client's previous waiver was not fully informed when given); ABA Task Force Report,

supra

note 16 (providing specific guidance to independent directors of funds when selecting and using legal counsel, and to counsel who advise independent directors). However, a lawyer's obligations in this regard envision that the lawyer assess the effect of the potential conflict first before informing the client,

see

ABA Model Rules, Rule 1.7(a)(1), and in any event may vary among different jurisdictions. The provision in our final rule concerning counsel's undertaking is intended to enable the independent directors to obtain the information they need in order to make their

own

determination about the independence of their counsel.

The final amendments rely on the independent directors to determine whether a person is an independent legal counsel. They must make this determination no less frequently than annually, and the basis for the determination must be recorded in the board's meeting minutes.

If the independent directors obtain information that their counsel has begun to represent a management organization or control person, they must determine whether this new representation—together with any other representations of management organizations and control persons—is unlikely to adversely affect the counsel's professional judgment.

In order to prevent the fund from losing the availability of the exemptions in these circumstances, the rule provides that counsel can still be considered “independent legal counsel” for up to three months, which will provide time for the independent directors to make a new determination about the counsel or to hire a new independent legal counsel.

We would not expect that the board meeting minutes would include detailed information such as law firm billing records. We would, however, expect the minutes to include material information the board considered and relied on in making its determination.

Rule 0-1(a)(6)(iii). This provision also would apply when conflicts arise as a result of a law firm merger, the hiring of a new partner or associate, the merger of two financial services firms, or as a result of a material increase in the scope or nature of the legal counsel's representation of a management organization.

Id.

In determining whether a counsel is an “independent legal counsel” under the rule, the judgment of the directors is not unbounded; it must be reasonable.

The independent directors should consider all relevant factors in evaluating whether the conflicting representations are “sufficiently limited.

For example, independent directors should consider (i) whether the representation is current and ongoing; (ii) whether it involves a minor or substantial matter; (iii) whether it involves the fund, the adviser, or an affiliate, and if an affiliate, the nature and the extent of the affiliation; (iv) the duration of the conflicting representation; (v) the importance of the representation to counsel and his firm (including the extent to which counsel relies on that representation economically); (vi) whether it involves work related to mutual funds;

and (vii) whether the individual who will serve as legal counsel was or is involved in the representation.

Applying these factors, we do not believe that independent directors could ordinarily conclude that a lawyer whose firm simultaneously represents the fund's adviser and independent directors in connection with matters as important to fund shareholders as the negotiation of the advisory contract

or distribution plan, or other key areas of conflict between the fund and its adviser, is an “independent legal counsel.”

Rule 0-1(a)(6)(i).

By adopting these rules, we do not intend to regulate the legal profession or to suggest that the existence of a professional relationship between the independent directors' counsel and a management organization would necessarily violate applicable codes of legal ethics. Moreover, we do not intend to create a presumption that a lawyer having such a professional relationship did not provide proper, objective legal advice, or that the board's reliance on its counsel was improper, or that any determination the board made based on counsel's advice was itself improper.

Whether counsel's representation of a management organization (or control person) is

unrelated

to a fund is a relevant factor for independent directors to consider when determining if the counsel may provide impartial advice to the independent directors. However, it is not a conclusive factor. Even if legal services are unrelated to a fund, those services may be so substantial, significant, or integral to the business of the management organization (or control person) that the independent directors could determine that the counsel is not an “independent legal counsel.”

We do not intend this list of factors to be an exhaustive or mandatory list of factors the directors must consider.

See, e.g.,

ABA Task Force Report,

supra

note 16, at 5-9 (providing guidance on factors that boards may wish to consider when assessing the quality and independence of their counsel).

After analyzing the factors, independent directors may, however, conclude that a counsel's representation of a fund's administrator or sub-adviser does not impede that counsel's ability to serve as an “independent counsel” to the independent directors. In evaluating whether representation of an administrator (or its control person) is “sufficiently limited” for the person to be an “independent counsel,” we believe a board could differentiate between an administrator that merely performs ministerial tasks and one that has sponsored, organized, or promoted the fund. Independent directors could reach a similar conclusion regarding a sub-adviser. The Act does not distinguish an adviser from a sub-adviser.

See

section 2(a)(20) of the Act (15 U.S.C. 80a-2(a)(20)). However, we believe that independent directors, in evaluating a counsel's conflicts, could give consideration to the nature of a sub-advisory relationship.

The ABA Task Force Report acknowledges that there are circumstances, such as litigation or other “obvious adversarial situations,” in which joint or multiple representations may never be appropriate. ABA Task Force Report,

supra

note 16, at 8. We agree, but believe that there are additional circumstances, due to the unique conflicts that are inherent in the structure of investment companies, in which independent directors should not accept joint and multiple representations.

We admonish directors to consider that your decision in selecting an independent counsel is not merely a matter of personal preference (as some commenters suggested), but an important exercise of your business judgment as an independent director.

The final rule makes it clear, however, that you are entitled to rely on information provided by counsel in forming your judgment.

As discussed below, the compliance date for the legal counsel provision is July 1, 2002.

See infra

Section III.

See

rule 0-1(a)(6)(ii). The independent directors are entitled to rely on that information unless they know or have reason to believe that the information is materially false or incomplete.

Id.

As a result, if counsel begins or materially increases the representation of a fund management organization but does not inform the independent directors, the independent directors can rely on the previous representation they received so that counsel's change in representation will not trigger the requirement that the independent directors make a new determination within three months.

See

rule 0-1(a)(6)(iii).

B. Limits on Coverage of Directors Under Joint Insurance Policies

We are adopting an amendment to rule 17d-1(d), which permits funds to purchase “errors and omissions” joint insurance policies for their officers and directors.

Currently, many of these policies contain exclusions when parties sue each other. As a result, independent directors of funds may not be covered against lawsuits by the adviser and consequently may be reluctant to take actions necessary to protect fund investors, out of concern for personal liability. Under the amendment, which we are adopting as proposed, rule 17d-1(d) is available only if the joint insurance policy does not exclude coverage for litigation between the adviser and the independent directors.

Commenters supported the proposed amendments, and agreed that they would allow independent directors to faithfully carry out responsibilities without concern for personal financial security.

Paragraph (d) of rule 17d-1 provides an exemption from paragraph (a) of the rule, which prohibits a fund affiliate from participating in any joint enterprise, joint arrangement, or profit sharing plan without first obtaining a Commission order.

See

rule 17d-1(d)(7)(iii). The amendments would prohibit exclusions for (i) bona fide (

i.e.,

non-collusive) claims made against any independent director by another person insured under the joint insurance policy, and (ii) claims in which the fund is a co-defendant with an independent director in a claim brought by a co-insured.

C. Independent Audit Committees

We are adopting new rule 32a-4 exempting funds from the Act's requirement that shareholders vote on the selection of the fund's independent public accountant if the fund has an audit committee composed wholly of independent directors.

The rule will permit continuing oversight of the fund's accounting and auditing processes by an independent audit committee, in place of the shareholder vote. Commenters agreed that the shareholder ratification has become largely perfunctory, and that an independent audit committee could exercise more meaningful oversight.

See

section 32(a)(2) of the Act [15 U.S.C. 80a—31(a)(2)].

Under the new rule, a fund is exempt from having to seek shareholder approval of its independent public accountant, if (i) the fund establishes an audit committee composed solely of independent directors that oversees the fund's accounting and auditing processes,

(ii) the fund's board of directors adopts an audit committee charter setting forth the committee's structure, duties, powers, and methods of operation, or sets out similar provisions in the fund's charter or bylaws,

and (iii) the fund maintains a copy of such an audit committee charter.

Some commenters questioned whether the proposed rule would require the audit committee to supervise a fund's day-to-day management and operations. The rule does not require, nor did we intend, that an audit committee perform daily management or supervision of a fund's operations.

Rule 32a-4(a).

Rule 32a-4(b).

Rule 32a-4(c). Commenters suggested that we permit the audit committee provisions to be set forth in the charter or bylaws of the fund. The final rule permits the fund either to adopt an audit committee charter or to set forth audit committee provisions in the fund's charter or bylaws. Rule 32a-4(b).

See

Audit Committee Disclosure, Exchange Act Release No. 41987 (Oct. 7, 1999) [64 FR 55648 (Oct. 14, 1999)] at text following n.26 (“We recognize how audit committees function may vary from

company to company, and companies need flexibility to determine all of the specific duties and functions of their audit committees.”).

D. Qualification as an Independent Director

In addition to the amendments to enhance the independence of fund boards, we are adopting a new rule to prevent qualified individuals from being unnecessarily disqualified from being considered an independent director. We are also rescinding a rule that has become unnecessary.

1. Ownership of Index Fund Securities

We are adopting new rule 2a19-3, which conditionally exempts an individual from being disqualified as an independent director solely because he or she owns shares of an index fund that invests in the investment adviser or underwriter of the fund, or their controlling persons.

As proposed, the exemption would have been available if the value of securities issued by the adviser or underwriter (or controlling person) did not exceed five percent of the value of any index tracked by the index fund. The purpose of this condition was to assure that an independent director's indirect interest in the adviser's securities would not be substantial enough to impair his or her independence and create a conflict of interest.

In response to some commenters' concerns that monitoring the five percent limit would be very difficult, we revised the rule so that it provides relief if a fund's investment objective is to replicate the performance of one or more “broad-based” indices.

Section 2(a)(19) of the Act disqualifies an individual 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 a controlling person of the adviser or underwriter. If a fund seeks to replicate the performance of a securities market index that includes securities of the fund's adviser (or principal underwriter or a controlling person of the adviser or principal underwriter), an issue could arise whether the director knowingly has an indirect beneficial interest in the securities of the adviser (or principal underwriter or controlling person).

See

Proposing Release,

supra

note 3, at n.138 and accompanying text.

The new rule does not address an independent director's ownership of securities of an

actively

managed fund that owns shares of the fund's adviser, underwriter or any of their controlling persons. As we discussed in the Proposing Release, we do not believe an independent director who owns shares of an actively managed fund would ordinarily “knowingly” have an indirect beneficial interest in the issuers of securities the fund holds, and thus ownership of such fund would not cause a director to be an “interested person” as defined by section 2(a)(19) of the Act.

See

Proposing Release,

supra

note 3, at n.140.

As we stated in the context of Form N-1A, a “broad-based index” is an index that “provides investors with a performance indicator of the overall applicable stock or bond markets, as appropriate. An index would not be considered to be broad-based if it is composed of securities of firms in a particular industry or group of related industries.”

See

Disclosure of Mutual Fund Performance and Portfolio Managers, Investment Company Act Release No. 19382 (Apr. 6, 1993) [58 FR 19050 (Apr. 12, 1993)] at n.21.

2. Affiliation with a Broker-Dealer

We are rescinding rule 2a19-1, which provides relief from the section of the Act that defines when a fund director is considered to be independent.

We had proposed to amend that rule to permit a slightly greater percentage of fund independent directors to be affiliated with registered broker-dealers, under certain circumstances. After our proposal, however, Congress passed the Gramm-Leach-Bliley Act, which amended section 2(a)(19) of the Investment Company Act and established new standards for determining independence under the circumstances we addressed in our proposal.

These amendments to the Act obviate the need for the exemptive relief provided by rule 2a19-1, and therefore we are rescinding the rule.

Sections 2(a)(19)(A)(v) and (B)(v) of the Act provide that no person can be an independent director if he or she is, or is affiliated with, a registered broker-dealer.

Section 213(a)(1) of the Gramm-Leach-Bliley Act incorporates the conditions of current rule 2a19-1(a)(1) under the Act. As amended, section 2(a)(19) now permits an independent director to be an affiliate of a broker-dealer, but not if the director or his or her affiliate has executed portfolio transactions for, engaged in principal transactions with, or distributed shares for the fund or certain related funds or accounts within the past six months. Pub. L. No. 106-102, § 213, 113 Stat. 1338, 1397-98 (1999), to be codified at 15 U.S.C. 80a-2(a)(19)(A)(v) and (B)(v).

Under the Administrative Procedure Act [5 U.S.C. 553(b)], notice of proposed rulemaking is not required if the agency for good cause finds “that notice and public procedure thereon are impracticable, unnecessary, or contrary to the public interest.” Section 213 of the Gramm-Leach-Bliley Act established new standards for determining independence under the circumstances addressed by rule 2a19-1, and the rule is no longer necessary. The Commission therefore finds that proposing the rescission of rule 2a19-1 for public comment is unnecessary.

E. Disclosure of Information about Fund Directors

We believe that shareholders have a significant interest in knowing who the independent directors are, whether the independent directors' interests are aligned with shareholders' interests, whether the independent directors have any conflicts of interest, and how the directors govern the fund. This information helps a mutual fund shareholder to evaluate whether the independent directors can, in fact, act as an independent, vigorous, and effective force in overseeing fund operations.

In reevaluating our current disclosure requirements, we concluded that, while our fundamental approach has been sound, there are several gaps in the information that shareholders currently receive about directors. We therefore proposed amendments to close these gaps. The proposal would require funds to:

• Provide basic information about directors to shareholders annually so that shareholders will know the identity and experience of their representatives;

• Disclose to shareholders fund shares owned by directors to help shareholders evaluate whether directors' interests are aligned with their own;

• Disclose to shareholders information about directors that may raise conflict of interest concerns; and

• Provide information to shareholders on the board's role in governing the fund.

We are adopting the disclosure amendments with several modifications designed to tailor the amendments more closely to our goal of providing shareholders with better information to evaluate the independent directors.

1. Basic Information

We are adopting the requirement to disclose basic information about directors in an easy-to-read tabular format, as proposed.

The table will be required in three places: the fund's annual report to shareholders, SAI, and proxy statement for the election of directors. The table will require for each director: (1) Name, address, and age; (2) current positions held with the fund; (3) term of office and length of time served; (4) principal occupations during the past five years; (5) number of portfolios overseen within the fund complex; and (6) other directorships held outside of the fund complex.

The table also requires for each interested director, as defined in Section 2(a)(19) of the Investment Company Act, a description of the relationship, events, or transactions by reason of which the director is an interested person.

Item 22(b)(1) of Schedule 14A; Items 13(a) and 22(b)(5) of Form N-1A; Item 18.1 and Instruction 4.e. to Item 23 of Form N-2; Item 20(a) and Instruction 4(v) to Item 27 of Form N-3. For convenience in discussing the requirements, we are not specifically referring to nominees for election as directors. The requirements, however, are applicable to nominees in proxy statements for the election of directors. The disclosure requirements in Item 22 of Schedule 14A also are applicable to information statements prepared in accordance with Regulation 14C and Schedule 14C [17 CFR 240.14c-101].

In response to privacy concerns raised by several commenters, we wish to clarify that a director may provide the address of the fund or the fund's adviser in the table and need not provide his personal address.

Commenters generally supported the proposal, although several commenters

opposed as unnecessary the requirement to describe in the table the relationships, events, or transactions that make certain directors “interested persons.” Funds are currently required to disclose this information in the proxy statement for the election of directors, and we are adopting this requirement as proposed.

We believe it is important that shareholders be provided with an explanation of why certain directors are “interested persons.”

Instruction 4 to Item 22(b)(1) of Schedule 14A; Instruction 2 to Item 13(a) of Form N-1A; Instruction 2 to Item 18.1 of Form N-2; Instruction 2 to Item 20(a) of Form N-3.

As discussed below, however, we are excluding interested directors from the new conflicts of interest disclosure requirements which we proposed in order to give shareholders better information about independent directors.

See infra

note 84 and accompanying text.

2. Ownership of Equity Securities in Fund Complex

We are adopting with modifications the requirement to disclose the amount of equity securities of funds in a fund complex owned by each director.

Commenters generally agreed with the Commission that disclosure of this information would be useful to shareholders in assessing whether directors' interests are aligned with those of shareholders.

Item 22(b)(5) of Schedule 14A; Item 13(b)(4) of Form N-1A; Item 18.7 of Form N-2; Item 20(f) of Form N-3.

(a) Disclosure of Amounts Owned by Directors

Many commenters expressed concern about the proposed requirement that funds disclose the exact dollar amount of securities directors own in a fund complex. These commenters argued that this disclosure would discourage potential directors from agreeing to serve, in order to avoid intrusions into their privacy, and might cause existing directors to reduce or sell their holdings to avoid publicity about their investments. As an alternative, many suggested that we require funds to disclose directors' equity ownership using specified dollar ranges, rather than exact dollar amounts. These commenters noted that using dollar ranges would provide shareholders with sufficient information to assess whether directors' interests were aligned with their own, making disclosure of exact dollar amounts unnecessary.

We are persuaded by these comments and have modified the proposal to require disclosure of a director's holdings of securities using dollar ranges rather than an exact dollar amount. Funds will be required to disclose directors' equity ownership using the following ranges: None; $1-$10,000; $10,001-$50,000; $50,001-$100,000; or over $100,000. We believe that disclosure of directors' holdings using these dollar ranges will provide investors with significant information to use in evaluating whether directors' interests are aligned with their own, while protecting directors' legitimate privacy interests.

(b) “Beneficial Ownership”

We received a number of comments requesting clarification about the types of director holdings that would be disclosed under the proposal. Based on these comments, we reevaluated our proposal to require disclosure of securities owned beneficially and of record by each director. Under the proposal, “beneficial ownership” would have been determined in accordance with rule 13d-3 of the Exchange Act, which focuses on a person's voting and investment power.

In light of our objective of providing information about the alignment of directors' and shareholders' interests, we believe that disclosure of record holdings should not be required and that the focus of “beneficial ownership” should be on whether a director's economic interests are tied to the securities, rather than his ability to exert voting power or to dispose of the securities. Therefore, we are modifying the proposal to require disclosure of “beneficial ownership” in accordance with the definition contained in rule 16a-1(a)(2) under the Exchange Act.

This definition, consistent with our goal, emphasizes the economic incidence of ownership.

17 CFR 240.13d—3.

17 CFR 240.16a-1(a)(2). We also have modified the proposal requiring disclosure of securities owned by an independent director and his immediate family members in an investment adviser or principal underwriter and persons controlling, controlled by, or under common control with an investment adviser or principal underwriter. This requirement is intended to illuminate potential conflicts of interest, and we therefore believe that any record or beneficial securities ownership in these entities should be disclosed, whether the beneficial ownership results from voting power, investment power, or economic interests. Therefore, we have revised the proposal to require disclosure of securities owned if covered by the definition of “beneficial ownership” contained in either rule 13d-3 or rule 16a-1(a)(2). Item 22(b)(6) and Instruction 2 to Item 22(b)(6) of Schedule 14A; Item 13(b)(5) and Instruction 2 to Item 13(b)(5) of Form N-1A; Item 18.8 and Instruction 2 of Item 18.8 of Form N-2; Item 20(g) and Instruction 2 of Item 20(g) of Form N-3.

We proposed to require aggregate disclosure of a director's holdings in a fund complex, rather than separate disclosure of a director's holdings in a particular fund. We were concerned that fund-specific 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. Several commenters recommended, however, that disclosure of a director's holdings should be made on a fund-by-fund basis, rather than a complex-wide basis, arguing that it would be more relevant to disclose to shareholders a director's ownership of the specific funds on whose board the director serves. Other commenters, agreed that disclosure of a director's holdings should be on an aggregate basis as proposed, but recommended that the disclosure be limited to a director's aggregate ownership in the funds overseen by a director within a fund complex. These commenters argued that disclosure in this manner is more useful to investors than complex-wide disclosure in assessing whether a director's interests are aligned with their own.

We are persuaded by these comments and have modified the proposal to require disclosure of: (1) Each director's ownership in each fund that he oversees; and (2) each director's aggregate ownership in any funds that he oversees within a fund family. We believe that a director's ownership in a particular fund provides the most direct indication of his alignment with the interests of shareholders in that fund. We continue to believe, however, that disclosure of a director's aggregate ownership will provide shareholders with relevant information about the director's alignment with shareholders. In addition, a director could have many reasons for not holding shares of a specific fund,

e.g.,

that its investment objectives do not match the director's. Disclosure of aggregate ownership will help prevent any inappropriate negative inference about fund management that a fund shareholder could draw from the fact that a director does not hold shares of a particular fund.

For purposes of determining a director's holdings in a fund complex, the Commission proposed to define “fund complex” as two or more funds that (1) hold themselves out to investors as related companies for purposes of investment and investor services; or (2) have a common investment adviser or an investment adviser that is an affiliated person of the investment

adviser of any of the other funds.

Many commenters argued that this definition would result in disclosure of holdings in funds that are too remotely related to funds on whose board the director serves to demonstrate alignment with fund shareholders (

e.g.,

for a director serving on the board of a fund with a sub-adviser, the director's ownership in any other funds that the sub-adviser serves would be disclosed, regardless of whether the funds are otherwise related). These commenters recommended that the Commission adopt a narrower definition of “family of investment companies,” which includes only funds that share the same investment adviser or principal underwriter and hold themselves out to investors as related companies for purposes of investment and investor services.

We agree with commenters that the proposed “fund complex” definition could result in disclosure of information having little bearing on a director's alignment with shareholders, and are adopting the narrower definition of “family of investment companies.”

Cf.

redesignated Item 22(a)(1)(vi) of Schedule 14A (definition of fund complex).

Cf.

Item H of Form N-SAR [17 CFR 274.101] (definition of “family of investment companies”).

Item 22(a)(1)(iv) of Schedule 14A; Instruction 1(a) to Item 13 of Form N-1A; Instruction 1.a to Item 18 of Form N-2; Instruction 1.a to Item 20 of Form N-3.

(d) Date of Disclosure

The equity ownership information must be included in the SAI and any proxy statement relating to the election of directors. For the proxy statement, the equity ownership information must be provided as of the most recent practicable date, as proposed, in order to ensure that shareholders receive up-to-date information when they are asked to vote to elect directors.

For the SAI, we have modified the proposal to require that the equity ownership information be provided as of the end of the last completed calendar year.

We believe that this modified time period requirement facilitates our goal that investors receive equity ownership information to evaluate whether directors' interests are aligned with their own, while imposing less of a burden on directors, especially those who serve multiple funds with staggered fiscal years.

Instruction 1 to Item 22(b)(5) of Schedule 14A.

Instruction 1 to Item 13(b)(4) of Form N-1A; Instruction 1 to Item 18.7 of Form N-2; Instruction 1 to Item 20(f) of Form N-3.

3. Conflicts of Interest

We are adopting our proposals on conflicts of interest disclosure, with modifications that tailor the requirements more closely to our goals and address commenters' concerns that some aspects of the proposal were overbroad.

We proposed to require funds to disclose in the proxy statement and SAI three types of circumstances that could affect the allegiance of fund directors to their shareholders: positions, interests, and transactions and relationships of directors and their immediate family members with the fund and persons related to the fund. The rules we adopt today follow this basic approach.

Items 22(b)(4), 22(b)(6), 22(b)(7), 22(b)(8), 22(b)(9), and 22(b)(10) of Schedule 14A; Items 13(b)(3), 13(b)(5), 13(b)(6), 13(b)(7), 13(b)(8), and 13(b)(9) of Form N-1A; Items 18.6, 18.8, 18.9, 18.10, 18.11, and 18.12 of Form N-2; Items 20(e), 20(g), 20(h), 20(i), 20(j), and 20(k) of Form N-3.

A number of commenters recommended alternatives to the proposed conflicts of interest disclosure requirements, including: (i) Requiring funds to maintain records of potential conflicts of interest of directors; (ii) permitting independent directors to determine for themselves whether or not conflicts of interest exist that affect the “independence” of other independent directors; and (iii) limiting conflicts of interest disclosure to the proxy statement for the election of directors. After careful consideration of these alternatives, we have determined that they would not constitute an adequate substitute for disclosure to shareholders.

We continue to believe that shareholders have a significant interest in information concerning circumstances that may affect the directors' allegiance to shareholders. None of the alternatives suggested by commenters would provide this information to shareholders on a regular basis. The first two alternatives would completely exclude shareholders from the process of evaluating the independence of directors. The third alternative, limiting conflicts of interest disclosure to the proxy statement for the election of directors, ignores the fact that the proxy statement has become an ineffective vehicle for communicating information to fund shareholders on a regular basis because funds generally are no longer required to hold annual meetings.

See

Proposing Release,

supra

note 3, at n.149 and accompanying text.

(a) Modifications to Persons Covered

(1) Interested Directors

We are modifying our proposal to exclude interested directors from the conflicts of interest disclosure requirements in both the SAI and proxy statement.

We are persuaded by the commenters' arguments that if the purpose of the conflicts of interest disclosure is to allow investors and the Commission staff to better evaluate the true independence of independent directors, this goal will not be achieved by requiring disclosure of interested directors' potential conflicts of interest. As previously discussed, however, funds will be required to describe the relationships, events, or transactions that make a director an interested person.

See supra

73 note and accompanying text. In addition, we are retaining the existing requirement that funds disclose positions held by interested directors with affiliated persons or principal underwriters of the fund. Item 22(b)(2) of Schedule 14A; Item 13(a)(2) of Form N-1A; Item 18.2 of Form N-2; Item 20(b) of Form N-3.

(2) Immediate Family Members

We are narrowing the scope of “immediate family members” covered by the disclosure requirements to a director's spouse, children residing in the director's household, and dependents of the director.

As proposed, “immediate family members” also included the director's parents, siblings, children not residing with the director, and in-laws.

Item 22(a)(1)(vii) of Schedule 14A; Instruction 1(c) to Item 13 of Form N-1A; Instruction 1.c to Item 18 of Form N-2; Instruction 1.c to Item 20 of Form N-3. The term “children” includes step and adoptive children. We are using the term “dependent” as defined in section 152 of the Internal Revenue Code. I.R.C. 152.

Proposed Item 22(a)(vi) of Schedule 14A; Proposed Instruction 1(b) to Item 13 of Form N-1A; Proposed Instruction 1.b. to Item 18 of Form N-2; Proposed Instruction 1.b. to Item 20 of Form N-3.

We received many comments on this definition, with the overwhelming majority of commenters arguing that the proposed extension of conflicts of interest disclosure to include a director's immediate family members, as defined in the proposal, was overly broad and too burdensome. Commenters noted that the definition, as proposed, would require directors to seek financial information from remote family members with whom they have little or no contact, and that the requirement could impose liabilities on directors without providing the means to enable directors to obtain the required information from reluctant relatives. We are persuaded by the commenters and have addressed their concerns by limiting the definition of “immediate family members” along the lines suggested by many commenters. The

narrower definition ensures that disclosure will only be required with respect to family members from whom directors can reasonably be expected to obtain the required information.

A number of commenters recommended that if the Commission adopted the proposed definition of “immediate family members,” disclosure of potential conflicts of interest should be limited to those of which the director had actual knowledge. Since we are narrowing the definition of “immediate family member,” incorporation of an actual knowledge standard is unnecessary.

(3) Related Persons

The Commission proposed to require disclosure about circumstances involving directors, on the one hand, and the fund and persons related to the fund, on the other. We are modifying the proposal to exclude administrators from the persons related to the fund that are covered by the requirements. Several commenters expressed concern that inclusion of administrators that are not affiliated with the fund's adviser or principal underwriter would produce irrelevant and unnecessary information for shareholders because interactions between directors and unaffiliated administrators would not create conflicts of interest that could affect an independent director's judgment. We are persuaded by these commenters and note that administrators that control, are controlled by, or are under common control with the adviser or principal underwriter will be covered by the conflicts of interest disclosure.

Items 22(b)(4)(iv), 22(b)(6)(ii), 22(b)(7)(ii), 22(b)(8)(vii), 22(b)(9), and 22(b)(10)(iii) of Schedule 14A; Items 13(b)(3)(iv), 13(b)(5)(ii), 13(b)(6)(ii), 13(b)(7)(vii), 13(b)(8), and 13(b)(9)(iii) of Form N-1A; Items 18.6(d), 18.8(b), 18.9(b), 18.10(g), 18.11, and 18.12(c) of Form N-2; Items 20(e)(iv), 20(g)(ii), 20(h)(ii), 20(i)(vii), 20(j), and 20(k)(iii) of Form N-3.

While some commenters also recommended excluding entities “under common control” with the adviser or principal underwriter, we believe that disclosure of interests, positions, and transactions and relationships with entities under common control is important and could highlight circumstances that potentially could affect the judgment of independent directors. We also note that the current proxy rules require disclosure with respect to commonly controlled entities.

See

Item 22(b)(1) of Schedule 14A (requiring independent directors to disclose direct or indirect securities interests in any person

under common control

with fund's adviser); Item 22(b)(3) (requiring all directors to disclose material transactions to which the adviser, principal underwriter, administrator, any parent or subsidiary of such entities (other than another fund), or any subsidiary of the parent of such entities was or is to be a party).

Although we are narrowing the scope of immediate family members and related persons in recognition of the overbreadth of our proposal in certain circumstances, we wish to emphasize that a fund's independent directors can vigilantly represent the interests of shareholders only when they are truly independent of those who operate and manage the fund. To that end, we encourage funds to examine any circumstances that could potentially impair the independence of independent directors, whether or not they fall within the scope of our disclosure requirements. There may, for example, be circumstances where an interest of a family member outside the ambit of our rules, or a director's interest in an administrator, impairs the director's ability to represent the interests of shareholders vigilantly.

(b) Other Modifications

(1) Threshold for Disclosure of Interests, Transactions, and Relationships

We are adopting a $60,000 threshold for disclosure of interests, transactions, and relationships.

Many commenters requested that the Commission establish a specific dollar threshold that would trigger the disclosure requirements to eliminate the need to make subjective “materiality” determinations. We are persuaded by these comments and are adopting the $60,000 threshold, a level recommended by many commenters and contained in the existing proxy rules.

Items 22(b)(7), 22(b)(8), and 22(b)(9) of Schedule 14A; Items 13(b)(6), 13(b)(7), and 13(b)(8) of Form N-1A; Items 18.9, 18.10, and 18.11 of Form N-2; Items 20(h), 20(i), and 20(j) of Form N-3. In the case of transactions, the $60,000 threshold applies to the size of a transaction, and a materiality standard applies to the director's or immediate family member's interest in the transaction. Item 22(b)(8) of Schedule 14A; Item 13(b)(7) of Form N-1A; Item 18.10 of Form N-2; Item 20(i) of Form N-3. The materiality of the interest is to be determined based on the significance of the information to investors in light of all the circumstances. Instruction 8 to Item 22(b)(8) of Schedule 14A; Instruction 7 to Item 13(b)(7) of Form N-1A; Instruction 7 to Item 18.10 of Form N-2; Instruction 7 to Item 20(i) of Form N-3. This is similar to a provision of the current proxy rules. Item 404(a) of Regulation S-K.

Cf.

redesignated Item 22(b)(11) of Schedule 14A; Item 404(a) of Regulation S-K. In determining whether the $60,000 threshold is exceeded for interests and relationships, a director's interest is to be aggregated with those of his immediate family members. Instruction 2 to Item 22(b)(7) and Instruction 6 to Item 22(b)(9) of Schedule 14A; Instruction 2 to Item 13(b)(6) and Instruction 5 to Item 13(b)(8) of Form N-1A; Instruction 2 to Item 18.9 and Instruction 5 to Item 18.11 of Form N-2; Instruction 2 to Item 20(h) and Instruction 5 to Item 20(j) of Form N-3.

We have replaced a materiality test with the $60,000 threshold in order to facilitate compliance with the disclosure requirements that we adopt today. This change does not, however, reflect a determination that the $60,000 threshold may be equated with “materiality.” We note that the antifraud provisions of the federal securities laws may obligate funds to disclose a material conflict of interest between a director and the fund or its shareholders without regard to the $60,000 threshold. For example, a transaction between a director and a fund's adviser may constitute a material conflict of interest with the fund or its shareholders that is required to be disclosed, regardless of the amount involved, if the terms and conditions of the transaction are not comparable to those that would have been negotiated at “arms-length” in similar circumstances.

(2) Time Periods

We are adopting, as proposed, a five-year time period for disclosure of positions and interests of directors and immediate family members in the proxy statement for the election of directors.

We are, however, reducing the time period for disclosure of positions and interests in the SAI to two calendar years.

We believe that, when a shareholder is asked to vote to elect directors, he is entitled to information about potential conflicts covering a significant period of time.

We recognize, however, that providing five years of information annually in the SAI, would, as suggested by commenters, increase fund compliance burdens without commensurate benefits to shareholders.

Items 22(b)(4) and 22(b)(7) of Schedule 14A.

Items 13(b)(3) and 13(b)(6) of Form N-1A; Items 18.6 and 18.9 of Form N-2; Items 20(e) and 20(h) of Form N-3.

Several commenters recommended that the Commission limit all conflicts of interest disclosure to a two-year period. These commenters argued that a two-year time period is consistent with the time limit for material business or professional relationships in section 2(a)(19) of the Act. We note, however, that the five-year time period for disclosure of positions and interests is currently required in the proxy rules. In fact, when the amendments to the proxy rules were adopted in 1994, most of the commenters that addressed the issue of time periods recommended limiting the disclosure of past relationships to the preceding five-year period.

See

Investment Company Act Rel. No. 20614 (Oct. 13, 1994) [59 FR 52689 (October 19, 1994)].

We are adopting, as proposed, the requirement to disclose material transactions and relationships since the beginning of the last two completed fiscal years in the proxy statement for the election of directors.

In the SAI, however, we have modified the proposal to require disclosure of transactions and relationships during the two most recently completed calendar years, rather than the last two

fiscal years as proposed.

Many commenters noted that a director may serve multiple funds with staggered fiscal years and that a requirement to disclose transactions and relationships for fiscal year time periods could require funds to obtain the information from directors as frequently as monthly, which would be overly burdensome. We have revised the proposal to require two calendar years of disclosure, rather than two fiscal years, in order to reduce this burden for funds with staggered fiscal years, while maintaining the requirement to include two years of disclosure.

Items 22(b)(8) and 22(b)(9) of Schedule 14A.

Items 13(b)(7) and 13(b)(8) of Form N-1A; Items 18.10 and 18.11 of Form N-2; Items 20(i) and 20(j) of Form N-3.

We also have modified the proposal to require funds to disclose in the SAI cross-directorships held by independent directors and their immediate family members during the last two most recently completed calendar years, rather than the last two fiscal years as proposed. Item 13(b)(9) of Form N-1A; Item 18.12 of Form N-2; Item 20(k) of Form N-3.

(3) Routine, Retail Transactions and Relationships

As proposed, the conflicts of interest disclosure provisions would not have required a fund to disclose routine, retail transactions and relationships, such as a credit card or bank or brokerage account, unless the director is accorded special treatment. At the request of commenters, we are clarifying that the exception for routine, retail transactions and relationships extends to residential mortgages and insurance policies.

We also note that the exception for routine, retail transactions and relationships is not limited to the specific transactions and relationships enumerated (credit cards, bank or brokerage accounts, residential mortgages, and insurance policies), but extends to other routine, retail transactions and relationships where the director is not accorded special treatment.

Instruction 11 to Item 22(b)(8) and Instruction 9 to Item 22(b)(9) of Schedule 14A; Instruction 10 to Item 13(b)(7) and Instruction 8 to Item 13(b)(8) of Form N-1A; Instruction 10 to Item 18.10 and Instruction 8 to Item 18.11 of Form N-2; Instruction 10 to Item 20(i) and Instruction 8 to Item 20(j) of Form N-3. We also note that sales load waivers granted to fund directors generally would not be required to be disclosed as “material” transactions or relationships, provided that such waivers are disclosed as otherwise required.

See

Instruction 3 to Item 18(c) of Form N-1A; Instruction 3 to Item 5.2 of Form N-2; Instruction to Item 23(b) of Form N-3 (requiring funds to provide explanations for any differences in the price at which securities are offered generally to the public and the prices at which securities are offered to any class of individuals).

4. Board's Role in Fund Governance

We are adopting, as proposed, disclosure requirements in the proxy rules and the SAI relating to a fund's committees of the board of directors, which commenters generally supported.

100

We are also adopting, as proposed, the requirement to disclose in the SAI the board's basis for approving an existing investment advisory contract.

101

100

Items 7(e) and 22(b)(14) of Schedule 14A; Item 13(b)(2) of Form N-1A; Item 18.5 of Form N-2; Item 20(d) of Form N-3.

101

Item 13(b)(10) of Form N-1A; Item 18.13 of Form N-2; Item 20(l) of Form N-3.

A number of commenters argued that information about the board's basis for approving an existing advisory contract is not relevant to an investment decision and disclosure of this information will be “boilerplate” in nature. After careful consideration of these comments, we continue to believe that shareholders should receive information in the SAI to help them evaluate the board's basis for approving the renewal of an existing investment advisory contract. In approving an investment advisory contract, independent directors must review the level of fees charged. Mutual funds fees and expenses, including advisory fees, are extremely important to shareholders. We note that the United States General Accounting Office (“GAO”), in a recent report to Congress on mutual fund fees, stressed the importance of heightening “investors” awareness and understanding of the fees they pay.

102

We believe that the rules we adopt today, which will ensure that shareholders receive specific information on how directors evaluate and approve fees on a regular basis, will help to address the GAO's concerns. In implementing this disclosure requirement, we remind funds that “boilerplate” disclosure is not appropriate. Funds are required to provide appropriate detail regarding the board's basis for approving an existing investment advisory contract, including the particular factors forming the basis of this determination.

102

United States General Accounting Office, Mutual Fund Fees: Additional Disclosure Could Encourage Price Competition (June 2000) at 97.

5. Separate Disclosure

We are adopting, as proposed, the requirement that funds present all disclosure for independent directors separately from disclosure for interested directors in the SAI, proxy statements for the election of directors, and annual reports to shareholders.

103

While several commenters argued that this requirement would confuse shareholders by overemphasizing the differences between independent and interested directors, we believe that the new disclosure format will assist shareholders in understanding information about directors, particularly in evaluating whether the independent directors can, in fact, act as an independent, vigorous, and effective force in overseeing fund operations.

104

103

Instruction 3 to Item 22(b) of Schedule 14A; Instruction 2 to Item 13 of Form N-1A; Instruction 2 to Item 18 of Form N-2; Instruction 2 to Item 20 of Form N-3.

104

We reiterate that funds may present information regarding independent and interested directors in a single table or chart, so long as the information for independent and interested directors is provided in separate sections within the table or chart.

See

Proposing Release,

supra

note, at text accompanying and following n.226.

6. Technical and Conforming Amendments

The Commission is adopting, as proposed, the technical and conforming amendments to its schedules, forms, and rules.

F. Recordkeeping Regarding Director Independence

We are adopting as proposed the amendments to rule 31a-2, to require funds to preserve for a period of at least six years any record of: (i) The initial determination that a director qualifies as an independent director, (ii) each subsequent determination of whether the director continues to qualify as an independent director, and (iii) the determination that any person who is acting as legal counsel to the independent directors is an independent legal counsel.

105

The rule amendments, which commenters supported, are designed to permit the Commission staff to monitor a fund's assessment of the independence of directors, and to ascertain whether a fund's assessment reflects diligent efforts to evaluate relevant business and personal relationships that might affect each director's independent judgment.

106

105

See

rule 31a-2(a)(4), (5).

106

For a discussion of the Commission staff's views on the types of professional and business relationships that may be considered material for purposes of sections 2(a)(19)(A)(vi) and (B)(vi) of the Act,

see

Interpretive Matters Concerning Independent Directors of Investment Companies, Investment Company Act Release No. 24083 (Oct. 14, 1999) [64 FR 59877 (Nov. 3, 1999)].

III. Effective Date; Compliance Dates

A. Effective Date

The new rules and amendments to rules and forms that the Commission is adopting today will become effective February 15, 2001. The rescission of rule 2a19-1 will become effective on May 12, 2001, the effective date of section 213 of the Gramm-Leach-Bliley Act.

B. Compliance Dates for Investment Company Act Rule Amendments

February 15, 2001.

Persons may begin to rely upon new rules 2a19-3, 10e-1 and 32a-4 on February 15, 2001, the effective date of these rules.

July 1, 2002.

After July 1, 2002: (i) persons may rely upon any of the Exemptive Rules (rules 10f-3, 12b-1, 15a-4(b)(2), 17a-7, 17a-8, 17d-1(d)(7), 17e-1, 17g-1(j), 18f-3, and 23c-3) only if they comply with each of the three new conditions for use of each rule; (ii) persons may rely upon rule 17d-1(d)(7) only if any joint insurance policy then in effect does not exclude coverage of litigation between the independent directors and another insured person under the amended rule;

107

and (iii) funds must begin to comply with the recordkeeping requirements of amended rule 31a-2.

107

See

rule 17d-1(d)(7)(iii).

C. Compliance Date for Disclosure Amendments

January 31, 2002.

All new registration statements and post-effective amendments that are annual updates to effective registration statements, proxy statements for the election of directors, and reports to shareholders filed on or after January 31, 2002 must comply with the disclosure amendments. Based on the comments, we believe that this will provide funds with sufficient time to make the necessary changes to disclosure documents. We note that a post-effective amendment that is filed for any purpose other than those specifically enumerated in paragraph (b)(1) of rule 485 is required to be filed pursuant to rule 485(a).

108

We would not, however, object if existing funds file their first annual update complying with the amendments pursuant to rule 485(b), unless information is included in response to the new conflicts of interest disclosure requirements, provided that the post-effective amendment otherwise meets the conditions for immediate effectiveness under the rule.

109

Thereafter, funds must make their own determination as to whether their annual updates should be filed pursuant to rule 485(a) or may be filed pursuant to rule 485(b) under the Securities Act.

110

108

17 CFR 230.485.

109

17 CFR 230.485(b). This also would apply to closed-end interval funds filing post-effective amendments pursuant to rule 486(b) under the Securities Act. 17 CFR 230.486(b).

110

17 CFR 230.485(a) and 230.485(b). Likewise, closed-end interval funds filing future post-effective amendments must determine whether they must file pursuant to rule 486(a) or may file pursuant to rule 486(b) of the Securities Act. 17 CFR 230.486(a) and 230.486(b).

III. Cost-Benefit Analysis

The Commission is sensitive to the costs and benefits imposed by its rules. In the Proposing Release, we requested comments and specific data regarding the costs and benefits of the proposed amendments to the Exemptive Rules

111

and the proposed new rules. Six commenters responded to our request for comments on the cost-benefit analysis. The commenters focused on a number of issues, particularly the independent counsel proposal and the disclosure proposals. These comments are addressed below.

111

See

Proposing Release,

supra

note , at text following n.33.

A. Amendments to the Exemptive Rules

The Commission is adopting the proposed amendments to the Exemptive Rules and the proposed new rules, with certain changes (together, the “Amendments”). The Amendments require that, for funds relying on those rules: (i) independent directors constitute a majority of their boards; (ii) independent directors select and nominate other independent directors; and (iii) any legal counsel for the fund's independent directors be an independent legal counsel. The Amendments are designed to enhance the independence and effectiveness of independent directors, who are charged with overseeing the fund's activities and transactions under the Exemptive Rules. Boards that meet these conditions should be more effective at exerting an independent influence over fund management. Their independent directors should be more likely to have their primary loyalty to the fund's shareholders rather than the adviser, and should be better able to evaluate the complex legal issues that are often faced by fund boards with an independent and critical eye. The Amendments, therefore, should provide substantial benefits to shareholders by helping to ensure that independent directors are better able to fulfill their role of representing shareholder interests and supplying an independent check on management. While these benefits are not easily quantifiable in terms of dollars, we believe that they are real, and that the Amendments will strengthen the hand of independent directors to the advantage of shareholders.

The Amendments may impose some costs on funds that choose to rely on the Exemptive Rules. These costs are discussed below. Funds that do not rely on an Exemptive Rule, however, will not be subject to the new conditions and should not incur any costs associated with those conditions.

112

One commenter stated that the Commission's proposed amendments and rules will increase the costs of relying on the Exemptive Rules, and that the “financial impact of the [Commission's] Proposal is underestimated.” The commenter did not provide specific dollar figures to quantify what it believed were more accurate reflections of the possible costs of the Amendments. Moreover, whether a particular fund incurs additional costs, and the amount of those costs, will depend upon a number of factors specific to the fund.

Independent directors as a majority of the board.

The Amendments require funds to have independent directors constitute a simple majority of their boards in order to rely on the Exemptive Rules. Because, as noted above, most mutual funds today have boards with independent majorities,

113

it appears that the Amendments will not impose substantial costs on funds as a group.

113

See

Proposing Release,

supra

note , at n.39 and accompanying text.

Funds that currently do not have a majority of independent directors on their boards and that would like to rely on the Exemptive Rules may incur some costs. The Commission, however, has no reasonable basis for estimating those costs. Those funds could come into compliance with the majority requirement of the Amendments in a number of ways. For example, funds could: (i) Decrease the size of their boards and allow some inside directors to resign; (ii) maintain the current size of their boards and replace some inside directors with independent directors; or (iii) increase the size of their boards and elect new independent directors.

If new independent directors are elected in order to comply with the Amendments, the fund would incur the costs of preparing a proxy statement and holding a shareholder meeting to elect those independent directors, as well as the costs of compensating those directors.

114

The Commission, however, has no reasonable basis for determining how many funds that currently do not have independent directors as a majority of their boards will choose to comply with the Amendments by electing new independent directors.

114

Under some circumstances a vacancy on the board may be filled by the board of directors.

See

section 16(a) of the Act. In those cases, the fund would not incur the costs of the proxy statement and shareholder meeting.

Independent director self-selection and self-nomination.

The Amendments require independent directors to select and nominate any other independent directors. This change should not impose significant new costs on funds, because many funds already have adopted this practice.

115

Although some

funds do not currently follow this practice and will need to adopt it in order to rely on the Exemptive Rules, we are not aware of any costs that would result from requiring a fund's incumbent independent directors to select and nominate other independent directors.

115

See

Proposing Release,

supra

note 3, at n.66 and accompanying text.

Independent legal counsel.

Lastly, the Amendments require any legal counsel to a fund's independent directors to be an independent legal counsel.

116

The Amendments do not require independent directors to retain legal counsel, but do require any person that acts as counsel to the independent directors to qualify as an independent legal counsel. Independent directors who are represented by counsel who does not meet the new definition of “independent legal counsel” thus may have to retain different counsel if their fund chooses to rely on any of the Exemptive Rules. If a substitution of counsel is necessary, it may lead to an increase in costs as described below.

116

As discussed above, we are amending rule 0-1 to include a definition of “independent legal counsel.”

See

Proposing Release,

supra

note 3, at n.87 and accompanying text;

see also infra

notes 120-125 and accompanying text (discussing the costs and benefits of this proposed definition).

B. Definition of Independent Legal Counsel

Rule 0-1 defines certain terms for purposes of the rules and regulations under the Investment Company Act. The Commission is amending this rule to add a definition of the term “independent legal counsel.” Under the new definition, a person is an independent legal counsel if a majority of the fund's independent directors determine, in the exercise of their business judgment, based on information obtained from such person, that any representation of the fund's adviser, principal underwriter, administrator,

117

or any of their control persons

118

since the beginning of the fund's last two completed fiscal years is unlikely to adversely affect the professional judgment of the person in providing legal representation to the independent directors. The basis of the independent directors' determination is required to be recorded in the minutes of the directors' meeting.

The new definition of “independent legal counsel” should help to ensure that independent directors' counsel is able to provide objective legal advice concerning the complex legal issues faced by those directors. This change thus should benefit both shareholders and independent directors by helping those directors to better carry out their responsibilities as shareholder representatives. Shareholders also will benefit from the requirement that the independent directors' determinations be recorded in the minute books of the fund, because this requirement will enable the Commission staff to review independent directors' determinations that their counsel qualifies as independent legal counsel.

117

In connection with this new definition, we also are amending rule 0-1 to define an “administrator” as any person who provides significant administrative or business affairs management services to a fund. This definition is substantially similar to the definition of administrator that is currently contained in Item 22(a)(1)(i) of Schedule 14A and Item 15(h)(1) of Form N-1A. Adding this definition to rule 0-1 should benefit funds by helping to clarify the scope of the definition of independent legal counsel. We are not aware of any costs that would be associated with this definition of administrator.

118

We are amending rule 0-1 to define “control person” as any person (other than a registered investment company) directly or indirectly controlling, controlled by, or under common control with a fund's investment adviser, principal underwriter, or administrator. This definition should benefit funds by helping to clarify the scope of the definition of independent legal counsel. We are not aware of any costs that would be associated with this definition.

The new definition will impose costs on some funds that rely on the Exemptive Rules.

119

We assume that approximately 3,200 funds rely on at least one of the Exemptive Rules annually.

120

We further assume that the independent directors of approximately one-third of those funds (1,065) would be required to make the specified determination in order for their counsel to meet the definition of “independent legal counsel.”

121

We estimate that each of these 1,065 funds would be required to spend, on average, 0.75 hours annually to comply with the proposed requirement that this determination be recorded in the fund's minute books,

122

for a total annual burden of approximately 799 hours. Based on this estimate, the total annual cost to funds of this new definition would be approximately $70,505.

123

We estimated in the Proposing Release that the cost of the new definition would be approximately $70,505, and one commenter argued that the actual cost of the proposed definition would “far exceed” that amount.

124

Another commenter stated that “there are likely to be substantial costs incurred by funds if they are forced to hire new counsel to independent directors because counsel has also represented the adviser.”

125

We do not believe the cost will “far exceed” the estimated amount. The rule relies solely on the independent directors to make a good faith determination that a person is an

independent counsel. We are unable to predict with any certainty how many independent directors will obtain new counsel because they determine that their current counsel is not “independent.” Each evaluation of counsel will be fact-specific, and each board will have to make its own determination with respect to its counsel. Some independent directors may choose not to hire their own legal counsel. The costs of obtaining new counsel also may be partially offset by savings generated by reductions in payment to current counsel, once they cease providing their services to the independent directors.

119

Among other things, the Amendments require that, for funds relying on those rules, any legal counsel for the independent directors of the fund be an “independent legal counsel.”

120

Based on statistics compiled by Commission staff from January 1, 1997 through December 31, 1998, we estimate that there are approximately 3,560 funds that could rely on one or more of the Exemptive Rules. Of those funds, we assume that approximately 90 percent (3,200) actually rely on at least one Exemptive Rule annually.

121

We assume that the independent directors of the remaining two-thirds of those funds (2,135) will choose not to have counsel (but instead rely in some circumstances on counsel who does not represent them), so that no determination by the independent directors would be necessary.

122

This estimate is based on a staff assessment of the burden associated with this proposed recordkeeping requirement in light of the estimated hour burdens currently associated with other rules under the Act that impose similar collection of information requirements.

123

To calculate this total annual cost, the Commission staff assumed that two-thirds of the total annual industry hour burden (532 hours) would be incurred by professionals with an average hourly wage rate of $125 per hour, and one-third of that annual hour burden (267 hours) would be incurred by clerical staff with an average hourly wage rate of $15 per hour ((532 × $125/hour) + (267 × $15/hour) = $70,505).

124

The commenter argued that, using the Commission's estimate, if the 1,065 funds that make a specific determination regarding “independent legal counsel” retain separate new counsel to represent them, the “total annual cost of the Commission's proposal will exceed $26 million” (assuming the average annual retainer for each separate counsel will be $25,000). While we agree that there may be additional costs imposed by rule 0-1 if a board finds its current counsel is not independent and wishes to retain new counsel, it is also likely that the cost of new counsel would be partially offset by the lower amount of fees to be paid to prior counsel. Some boards may decide against appointing counsel. Moreover, the amended rule is different from the proposed rule, and gives the independent directors sole discretion to determine whether their counsel is independent. Thus, the overall additional costs should be far less than those suggested by the commenter.

125

This commenter suggested that there would be additional costs associated with new counsel, which would need to familiarize itself with the fund, its charter documents, its contracts, the service providers, and other information in order to effectively represent the fund's independent directors. Similarly, the commenter stated that as mergers and acquisitions of fund advisers accelerate, many fund boards will increasingly have to look to outside counsel as one of the few, if not the only, source of continuity and institutional knowledge. We agree that costs may be incurred if the independent directors retain new counsel. However, the Commission cannot predict with any certainty how often this will occur, or the fees charged by the new counsel. Moreover, as law firms experience their own mergers, acquisitions, and turnover of attorneys, new lawyers frequently must familiarize themselves with the fund and its operations. These are costs that law firms would and might pass on to funds whether or not we adopt the new rule.

The same commenter also expressed concern that the Proposing Release did not factor the costs of law firms to initially screen and thereafter continuously monitor legal work performed to ensure continued independence. Most law firms already screen and monitor any new matters for conflicts of interest. We do not believe that our rules will affect this screening and monitoring, nor do we believe law firms will have to establish new systems for the initial screening and continued monitoring of conflicts.

C. Suspension of Board Composition Requirements

New rule 10e-1 will increase the periods for which the independent director minimum percentage requirements of the Act, and of the rules under the Act, are temporarily suspended if the death, disqualification, or bona fide resignation of an independent director causes the representation of independent directors on the board to fall below that required by the Act or our rules. The new rule will benefit funds by helping to ensure that if a fund's board falls below the independent director minimum percentage requirements in these circumstances, the fund will not immediately face the severe consequences of losing the availability of the Exemptive Rules.

One commenter stated its opinion that there will be significant costs imposed on funds if the time periods suggested in the Proposing Release were not increased. We extended one of the proposed time periods for rule 10e-1 in response to concerns voiced by commenters, and we believe that the periods for which the rule would suspend the independent director minimum percentage requirements are consistent with concerns for investor protection. As amended, the new rule appears not to have any costs for investors or funds.

D. Limits on Coverage of Directors under Joint Insurance Policies

Rule 17d-1(d)(7) under the Act permits funds to purchase joint liability insurance policies without first obtaining a Commission order permitting this joint arrangement, provided that certain conditions are met. The Commission is amending this rule to make it available only for joint liability insurance policies that do not exclude coverage for independent directors' litigation expenses in the event that they are sued by the fund's adviser. This change should benefit shareholders by making it possible for independent directors to engage in the good faith performance of their responsibilities under the Act and our rules without concern for their personal financial security. For the same reasons, the rule change also should benefit independent directors.

Because obtaining this type of coverage may cause the premiums charged by some insurance providers for joint liability insurance policies to increase, this amendment may have some costs for funds.

126

The Commission, however, has no reasonable basis for estimating the possible increase in premiums that may result from this proposal.

126

The ICI Mutual Insurance Company (“ICI Mutual”), which insures funds representing approximately 70 percent of all open-end fund assets, announced last year that it was making available to funds a standard policy endorsement that permits independent directors to recover defense costs, settlements, and judgments in “insured vs. insured” claims otherwise covered under the policy.

See

Proposing Release,

supra

note , at n.111. According to an ICI Mutual representative, that company is not charging funds any additional premiums for this coverage. It is possible, however, that other insurance providers might charge funds additional premiums for providing this type of coverage.

E. Independent Audit Committees

Section 32(a)(2) of the Act requires that the selection of a fund's independent public accountant be submitted to shareholders for ratification or rejection. New rule 32a-4 exempts a fund from this requirement if the fund has an audit committee consisting entirely of independent directors to oversee the fund's auditor. The new rule could provide significant benefits to shareholders. Many believe shareholder ratification of a fund's independent auditor has become a perfunctory process, with votes that are rarely contested. As a consequence, we believe that the ongoing oversight provided by an independent audit committee can provide greater protection to shareholders than shareholder ratification of the choice of auditor. In addition, funds that rely on section 32(a)(2) will no longer have to obtain shareholder ratification or rejection of their auditor on an annual basis, and this change should save some printing costs with respect to proxy materials.

New rule 32a-4 may impose certain costs on those funds that choose to rely on the exemption. It appears that these costs will likely be minimal and will be justified by the relief provided by the exemption. To rely on the exemption, among other things, a fund's board of directors must adopt an audit committee charter that sets forth the committee's structure, duties, powers, and methods of operation, or similar audit committee provisions must appear in the fund's charter or bylaws. The fund also must preserve that charter, and any modifications to the charter, permanently in an easily accessible place.

127

We estimate that there are approximately 3,490 investment companies that may rely on the proposed rule.

128

We assume that approximately 15 percent (524) of those funds are likely to rely on the exemption. For each of those funds, we estimate that the adoption of the audit committee charter would require, on average, 2 hours of director time and 2 hours of professional time,

129

for a total one-time burden of approximately 2,096 hours, and a total one-time cost of approximately $655,000.

130

We also estimate that each of the funds relying on the rule would be required to spend approximately 0.2 hours annually to comply with the proposed requirement that they preserve permanently their audit committee charters,

131

for an additional total annual hour burden of 105 hours, and an additional total annual cost of approximately $5,425.

132

127

These conditions are designed to enable the Commission staff to monitor the duties and responsibilities of an independent audit committee formed by a fund relying on the exemption.

128

This estimate is based on statistics compiled by Commission staff from January 1, 1997 through December 31, 1998.

129

This estimate is based on a review of the estimated hour burdens currently associated with other rules under the Act that impose similar collection of information requirements.

130

To calculate this one-time cost, the Commission staff used $500 per hour as the average cost of directors' time and $125 per hour as an average hourly wage for professionals ((2 hours × 524 funds × $500/hour) + (2 hours × 524 funds × $125/hour) = $655,000).

131

This estimate is based on a review of the estimated hour burdens associated with other rules under the Act that impose similar collection of information requirements.

132

To calculate the total annual cost of the proposed rule, the Commission staff assumed that one-third of the total annual hour burden (35 hours) would be incurred by professionals with an hourly wage rate of $125 per hour, and two-thirds of that annual hour burden (70 hours) would be incurred by clerical staff with an hourly wage rate of $15 per hour ((35 × $125/hour) + (70 × $15/hour) = $5,425).

In addition, some funds pay their directors an extra fee for each committee on which they serve.

133

Those funds may incur the additional costs of audit committee fees if they establish an audit committee in order to rely on the proposed exemption. Of those funds likely to rely on the exemption, however, we have no basis for determining the number that would pay

their independent directors a separate fee for service on the audit committee, or the likely amount of those fees.

134

133

In some cases, funds pay these additional committee fees only if the committee meeting is held on a day when a board meeting is not scheduled.

134

We also have no basis for determining how many funds would choose to avoid those fees by scheduling audit committee meetings for the same day as a board meeting.

F. Qualifications as an Independent Director

New rule 2a19-3 should benefit shareholders, funds, and independent directors by working to prevent qualified individuals from being unnecessarily disqualified from serving as independent directors. New rule 2a19-3 will benefit both funds and their independent directors by clarifying the status of independent directors who own shares of index funds.

The Commission is not aware of any costs to funds that would result from the new rule. There also should be no costs to investors because, consistent with concerns for investor protection, the new rule will not permit individuals who have affiliations or business interests that could impair their independence to serve as independent directors. The new rule applies to funds that replicate a broad-based index or indices, and does not include the five percent threshold of the proposed rule, and therefore funds will not have to monitor the percentage of an index that is made up of the securities of the fund's adviser, lead underwriter, or their controlling persons.

135

See supra

Section I.E.2.

G. Disclosure of Information about Fund Directors

In the Proposing Release, we analyzed the costs and benefits of our proposals and requested comment and data regarding the costs and benefits of the disclosure amendments. A few commenters specifically addressed the Commission's estimates, and they generally argued that the Proposing Release underestimated the costs to be incurred in connection with the proposed amendments. The commenters, however, did not provide specific cost or benefit data in response to the Proposing Release. As discussed above, after careful consideration of the comments we received in response to our Proposing Release, we have tailored the disclosure requirements to better achieve our goals and also addressed the concerns of commenters by modifying the scope of the proposed disclosure amendments.

The amendments to the proxy rules and Forms N-1A, N-2, and N-3 will provide fund investors with improved information about directors. Because independent directors are the shareholders' representatives and advocates, shareholders have a significant interest in knowing who the independent directors are, whether the independent directors' interests are aligned with shareholders' interests, whether the independent directors have any conflicts of interest, and how the directors govern the fund. This information will help a fund shareholder evaluate whether his designated representatives can, in fact, act as independent, vigorous, and effective representatives.

We believe that the amendments benefit investors in several ways. The requirement that mutual funds disclose basic information about directors in an easy-to-read tabular format in the fund's annual report to shareholders, SAI, and proxy statements for the election of directors benefits shareholders by ensuring that shareholders receive information about the identity and experience of their directors both annually and whenever they are asked to vote to elect directors. Moreover, this information benefits prospective investors who may obtain the information, without charge, upon request.

The amendments require that funds disclose: (1) Each director's ownership in each fund that he oversees; and (2) each director's aggregate ownership in any funds that he oversees within a fund family. This information benefits shareholders and prospective investors by making available in the SAI information that may show the alignment of director interests with those of shareholders. In addition, shareholders also benefit by receiving this information in the proxy statements whenever they are asked to vote to elect directors.

Our amendments regarding circumstances that may raise conflict of interest concerns for directors benefit investors by enabling investors to decide for themselves whether an independent director would be an effective advocate for shareholders. Disclosure of this type of information also results in its public dissemination, bringing these circumstances to the attention of fund shareholders, and encouraging the selection of independent directors who are independent in the spirit of the Act. Finally, this information assists the Commission in determining whether to exercise its authority under section 2(a)(19) of the Act to find that a person is an interested person of a fund by reason of having had, at any time since the beginning of the last two completed years of the fund, a material business or professional relationship with the fund and certain persons related to the fund.

The modifications to the disclosure requirements of matters related to the board's role in governing a mutual fund benefit shareholders by allowing them to determine more readily whether the directors are effectively representing shareholders' interests, independent of fund management.

The amendments impose certain costs on the fund industry. The costs associated with the proposed amendments include the resources expended by funds in collecting the information and preparing the disclosure documents.

136

Although we have tailored the proposal to better achieve our goals and to address the concerns of commenters, we do not believe that the overall cost burden of the amendments was materially affected.

136

One commenter argued that the Commission failed to account for the costs to funds when potential and existing directors are discouraged from serving on fund boards due to the burdens of the proposed disclosure amendments. The commenter, however, failed to provide any quantifiable data to support the commenter's argument. Moreover, in tailoring the disclosure amendments to better achieve our goals, we have addressed the concerns of commenters regarding the scope of the disclosure requirements.

Another commenter noted that the Commission failed to account for the legal costs associated with increased litigation that would arise from the new disclosure requirements. Again, the commenter failed to provide any data for us to consider.

Proxy Statements

The hour burden for preparing proxy statements at the time of the Proposal Release was 96.2 hours per proxy statement, and we estimated that approximately

1/3

of those hours—or 32 hours—are expended collecting and disclosing information about directors and nominees.

137

We estimated the additional burden hours that would be imposed by the proposed disclosure requirements to be 10 hours per proxy statement.

138

137

This estimate was based on a staff assessment of the different types of information required in proxy statements.

138

This estimate was based upon a staff assessment of the proposed amendments in light of the hour burden and reporting requirements at the time of the Proposal Release.

As stated above, the additional hours were based on the additional time funds would devote to determining what information needs to be disclosed, formulating queries for directors, and preparing the disclosure documents.

We estimate the annual industry cost of the proposed amendments to the proxy statements to be 10,000 hours, or $1.25 million, based on an estimated 1,000 proxy statements that are filed annually.

139

The estimated number of proxy statements was based on the approximate number of proxy

statements filed with the Commission in calendar year 1998. The total industry cost of the proposed amendments to the proxy statement is calculated by multiplying the annual number of proxy statements (1,000) by the additional hour burden imposed by the proposed amendments (10 hours) by the hourly wage rate ($125). The hourly wage rate is based upon consultations with a sample of filers and represents the Commission's estimate for an appropriate wage rate for the legal, financial, and accounting skills commonly used in preparation of registration statements, shareholder reports, and proxy statements.

Registration Statements

Because the information to be disclosed in the registration statements is the same as in the proxy statements, we believe that the hour burden for the amendments per registration statement will be approximately the current hour burden for collecting and disclosing director information under the current proxy rules plus the hour burden for the proposed amendments to the proxy rules. As stated above, we estimated the current hour burden for collecting and disclosing information about directors and nominees in proxy statements to be 32 hours per proxy statement and the burden hours for collecting and disclosing the enhanced information about directors and nominees to be 10 hours per proxy statement, for a total of 42 hours.

Form N-1A

The hour burden for Form N-1A is on a per portfolio basis and not per registration statement filed with the Commission. Based on the staff's experience with Form N-1A, we estimate that there are approximately 1.75 portfolios per registration statement filed on Form N-1A. The average hour burden per portfolio for disclosing the information about directors will be the hour burden per registration statement (42) divided by the average number of portfolios per registrant (1.75), or 24 hours per portfolio.

140

Because mutual funds only have to update information in post-effective amendments, we expect the hour burden to be

1/6

of the hours expended for the initial registration statement, or 4 hours per portfolio for post-effective amendments.

141

140

Our estimated hour burden would be high for those portfolios that are part of a fund complex in which multiple registered investment companies have the same board of directors because the burden of collecting and disclosing information about the common board would be spread over a larger number of portfolios.

141

Although funds only have to update the information about current directors and add information about new directors, we anticipate that funds will incur some burden hours in regularly collecting information from directors, determining what information needs to be disclosed, and preparing the updated disclosure information.

In the Proposing Release, we estimated that 280 portfolios file initial registration statements and 7,875 portfolios file post-effective amendments annually on Form N-1A.

142

Thus, we estimate the annual industry cost of the amendments to Form N-1A to be 38,220 hours, or $4.78 million.

143

142

These estimates were based on filings received in calendar year 1998.

143

The total annual industry cost is calculated by multiplying the total annual industry hour burden ((280 portfolios x 24 hours) + (7,875 portfolios x 4 hours)) by the hourly wage rate of $125.

Form N-2

The hour burden for Form N-2 is on a per registration statement basis because funds registering on Form N-2 register one portfolio per registration statement. Because the disclosure will be the same for Form N-2 as for Form N-1A, except that it would be for one portfolio per registration statement, we estimated the additional hour burden for the proposed amendments to be 42 hours for each initial registration statement. Because funds only have to update information in post-effective amendments, we expect that the hour burden to be approximately

1/6

of the hours expended for the initial registration statement, or 7 hours per post-effective amendment.

144

In the Proposing Release, we estimated that 110 funds file initial registration statements and 20 file post-effective amendments annually on Form N-2.

145

Thus, we estimate the annual industry cost of the amendments to Form N-2 to be 4,760 hours, or $595,000.

146

145

These estimates were based on filings received in calendar year 1998.

146

The total annual industry cost is calculated by multiplying the total annual industry hour burden ((110 funds x 42 hours) + (20 funds x 7 hours)) by the hourly wage rate of $125.

Form N-3

The hour burden for Form N-3 is on a per portfolio basis and not per registration statement filed with the Commission. Based on the Commission staff's experience with Form N-3, we estimate that there are approximately 4 portfolios per investment company registering on Form N-3. The average hour burden per portfolio for disclosing the information about directors will be the hour burden per registration statement (42) divided by the approximate number of portfolios per registrant (4), or 10.5 hours per portfolio. Because funds only have to update information in post-effective amendments, we expect that the hour burden would be

1/6

of the hours expended for the initial registration statement, or 1.75 hours per portfolio for post-effective amendments.

147

Although funds would only have to update the information about current directors and add information about new directors, we anticipate that funds would incur some burden hours in regularly collecting information from directors, determining what information needs to be disclosed, and preparing the updated disclosure information.

In the Proposing Release, we estimated that 20 portfolios file initial registration statements and 40 portfolios file post-effective amendments annually on Form N-3.

148

Thus, we estimate the annual industry cost of the amendments to Form N-3 to be 280 hours, or $35,000.

149

148

These estimates were based on filings received in calendar year 1998.

149

The total annual industry cost is calculated by multiplying the total annual industry hour burden ((20 portfolios x 10.5 hours) + (40 portfolios x 1.75 hours)) by the hourly wage rate of $125.

Shareholder Reports

Because the disclosure of basic tabular information, which is required in annual shareholder reports, is a subset of the information that would be required in the initial registration statement of a fund and any post-effective amendments, we expect that the annual burden for complying with the proposed amendments to the shareholder report requirements would be minimal. Based upon the amount of information to be disclosed, we estimate that the hour burden would be one-half hour per investment company for each annual shareholder report. In the Proposing Release, we estimated that there were 3,490 management investment companies that are subject to the annual report requirements.

150

Thus, we estimate the annual industry cost of the proposed amendments for annual shareholder reports to be 1,745 hours, or $218,125.

151

150

This estimate was based on statistics compiled by Division staff from January 1, 1997 through December 31, 1998.

151

The industry cost of the proposed annual shareholder reporting requirements is calculated by multiplying the total annual hour burden for the industry (0.5 hours x 3,490 registered management investment companies) by the hourly wage rate of $125.

H. Recordkeeping Regarding Director Independence

The Commission also is amending rule 31a-2 under the Act, which requires funds to preserve certain records for specified periods of time. The amendments to rule 31a-2 require funds to preserve for a period of at least six years any record of: (i) The initial determination that a director qualifies as

an independent director; (ii) each subsequent determination of whether the director continues to qualify as an independent director; and (iii) the determination that any person who is acting as legal counsel to the independent directors is an independent legal counsel. These amendments should benefit both shareholders and the Commission by enabling the Commission's staff to monitor the independent directors' determination of whether their counsel is independent.

The amendments will impose certain minimal costs on funds. The Commission staff estimates that each fund currently spends about 27.8 hours per year complying with the record preservation requirements of rule 31a-2.

152

Approximately 3,490 funds would be affected by the proposal to amend the rule to require funds to preserve records regarding the independence of their directors.

153

The Commission staff estimates that each of those funds would be required to spend an additional 0.2 hours annually to comply with the proposed amendment,

154

for a total additional burden for all funds of approximately 698 hours. Based on this estimate, the total annual cost for all funds of the proposed amendment to rule 31a-2 would be $36,100.

155

The estimated costs related to the determination of counsel's independence are discussed above in section IV.B. The Commission is not aware of any other costs that would result from the proposed amendments to rule 31a-2.

152

Commission staff surveyed representatives of several funds to determine the current burden hour estimate for rule 31a-2.

153

This estimate is based on statistics compiled by Commission staff from January 1, 1997 through December 31, 1998.

154

This estimate is based on a Commission staff assessment of the hour burden that would be imposed by the proposed amendment in light of the estimated hour burden currently imposed by the requirements of the rule.

155

In calculating the total annual industry cost of the proposed amendment, the Commission staff assumed that one-third of the total annual industry hour burden (233 hours) would be incurred by professionals with an average hourly wage rate of $125 per hour, and two-thirds of that annual hour burden (465 hours) would be incurred by clerical staff with an average hourly wage rate of $15 per hour ((233 x $125/hour) + (465 x $15/hour) = $36,100).

V. Effects on Efficiency, Competition and Capital Formation

Section 2(c) of the Investment Company Act, section 2(b) of the Securities Act, and section 3(f) of the Exchange Act require the Commission, when engaging in rulemaking that requires it to consider or determine whether an action is consistent with the public interest, to consider, in addition to the protection of investors, whether the action will promote efficiency, competition and capital formation.

156

The Commission has considered these factors.

156

15 U.S.C. 80a-2(c), 77b(b), and 78c(f).

Independent directors have significant responsibilities under the Investment Company Act and the Exemptive Rules. The new rules and amendments are intended to enhance the independence and effectiveness of independent directors so that they can perform these responsibilities capably and well. The new rules and rule amendments should promote capital formation by bolstering investors' confidence in the ability of independent directors to represent their interests effectively. When investors are confident that their interests are duly considered by those responsible for the operation of the mutual funds in which they invest, they are more likely to continue to rely on mutual funds as a vehicle for savings and investment. The new rules and rule amendments should promote efficiency and competition by enhancing the ability of fund independent directors to scrutinize fund operations and protect funds from inefficiencies inherent when a fund is operated to promote the interests of persons other than those who have invested in the fund.

As discussed above, shareholders have a significant interest in knowing who the independent directors are, whether the independent directors' interests are aligned with shareholders' interests, whether the independent directors have any conflicts of interest, and how the directors govern the fund. This information helps a fund shareholder to evaluate whether the independent directors can, in fact, act as an independent, vigorous, and effective force in overseeing fund operations. The disclosure amendments were designed to ensure that shareholders have the information necessary to make such evaluations.

It is unclear whether the disclosure amendments will promote the efficiency of funds since the disclosure amendments do not change the operation of funds. The disclosure amendments, however, may promote competition among funds since shareholders will now be better equipped to evaluate the effectiveness of fund boards among various funds before making their investment decisions. The disclosure amendments also may promote capital formation as the disclosure amendments may provide potential investors greater confidence to invest in funds knowing that the interests of the independent directors overseeing the funds are aligned with their own.

VI. Paperwork Reduction Act

As explained in the Proposing Release, certain provisions of Forms N-1A, N-2, and N-3, and rules 0-1, 20a-1, 30e-1, 31a-2, and 32a-4 under the Investment Company Act, and Schedule 14A under the Exchange Act contain “collection of information” requirements within the meaning of the Paperwork Reduction Act of 1995 [44 U.S.C. 3501-3520.]. We published notice soliciting comments on the collection of information requirements in the Proposing Release and submitted these requirements to the Office of Management and Budget (“OMB”) for review in accordance with 44 U.S.C. 3507(d) and 5 CFR 1320.11.

As discussed above, we are adopting the disclosure amendments with several modifications designed to tailor the amendments more closely to our goal of providing shareholders with better information to evaluate the independent directors. Specifically, we are adopting disclosure amendments that will require funds to disclose: (1) Basic information about directors in an easy-to-read tabular format; (2) fund shares owned by directors; (3) conflicts of interest information regarding independent directors; and (4) information on the board's role in governing the fund.

A few commenters specifically addressed the burden hours the Commission estimated funds would incur to satisfy the proposed disclosure requirements, generally stating that these estimates were too low. These commenters, however, did not provide the Commission with any specific quantitative data regarding burden hours.

157

As discussed in the Proposing Release, the Commission staff estimated the burden hours that would be necessary under the proposed disclosure amendments by assessing a variety of factors.

158

After careful

consideration of these comments, as well as the modifications made to the amendments as proposed, we continue to believe that our estimates are appropriate.

159

157

One commenter did assert that an additional 250 hours would be required to convert the new disclosure requirements into “plain English” in order for funds to obtain accurate information from directors. In light of the modifications to the disclosure requirements discussed above, which simplified the disclosure requirements, we believe that our estimates remain appropriate.

158

For example, in determining the burden hour for preparing proxy statements, we explained that the then current hour burden for preparing proxy statements was 96.2 hours per proxy statement, and we estimated that approximately

1/3

of those hours—or 32 hours—were expended collecting and disclosing information about directors and nominees. We estimated that an additional 10 burden hours per proxy statement would be imposed by the proposed disclosure requirements.

This estimate was based upon a Commission staff assessment of the proposed amendments in light of the then current hour burden and current reporting requirements. We explained that the additional hours were based on the additional time funds would devote to determining what information needs to be disclosed and preparing the disclosure documents.

159

We note that since issuing the Proposing Release, the Commission issued a proposal on Disclosure of Mutual Fund After-Tax Returns, Investment Company Act Release No. 24339 (March 15, 2000) [65 FR 15500 (March 22, 2000)]. The proposal would result in an increase in burden hours of 109,591 for Form N-1A and 17,100 burden hours for rule 30e-1 due to the proposed amendments relating to after-tax disclosure.

The rule amendments we are adopting in this Release include amendments to the Exemptive Rules that are designed to enhance the independence and effectiveness of fund independent directors.

160

The changes also include new rules and rule amendments that will prevent qualified individuals from being unnecessarily disqualified from serving as independent directors, protect independent directors from the costs of legal disputes with fund management, permit the Commission to monitor the independence of directors by requiring funds to preserve records of their assessments of director independence, and temporarily suspend the independent director minimum percentage requirements if a fund falls below the required percentage due to an independent director's death or resignation. In addition, the Commission is exempting funds from the requirement that shareholders ratify or reject the directors' selection of an independent public accountant, if the fund establishes an audit committee composed entirely of independent directors.

160

These amendments require that, for funds relying on any of the Exemptive Rules, (i) independent directors constitute a majority of the fund's board of directors; (ii) independent directors select and nominate other independent directors; and (iii) any legal counsel for the independent directors be an independent legal counsel. In connection with these amendments, we also are amending rule 0-1 under the Act to add definitions of the terms “independent legal counsel” and “administrator.”

In the Proposing Release, the Commission estimated the burden hours that would be necessary for the collection of information requirements under the proposed amendments to the rules under the Act. Although no commenters specifically addressed the burden estimates for the collection of information requirements, a few commenters responding to the cost-benefit analysis in the Proposing Release generally stated that we had underestimated the burden hours. These commenters, however, did not provide an estimate of the burden hours associated with the proposed rule changes. We continue to believe that the estimates of the burden hours contained in the Proposing Release are appropriate.

161

The Commission continues to estimate that the addition of the definition of the term “independent legal counsel” to rule 0-1 will require the independent directors of approximately 1,065 funds to spend, on average, 0.75 hours annually to determine whether their counsel meets the definition of “independent legal counsel,” for a total annual burden of approximately 799 hours.

See

Proposing Release,

supra

note 3, at nn.287-290 and accompanying text.

In addition, the Commission estimates that the amendments to rule 31a-2, which require funds to preserve records regarding the independence of their directors and counsel, will require approximately 3,490 investment companies to spend an additional 0.2 hours annually to comply with the collection of information requirements of rule 31a-2, for a total additional burden for all funds of approximately 698 hours.

See

Proposing Release,

supra

note 3, at nn.310-312 and accompanying text.

The Commission also estimates that new rule 32a-4, which provides an exemption from the requirement in section 32(a)(2) of the Act that the selection of a fund's independent public accountant be submitted to shareholders for ratification or rejection, will be relied upon by approximately 524 funds, for a total one-time burden of 2,096 hours and an additional annual hour burden of 105 hours.

See

Proposing Release,

supra

note 3, at nn.313-314 and accompanying text.

OMB approved the collection requirements contained in the forms and rules. Forms N-1A (OMB Control No. 3235-0307), N-2 (OMB Control No. 3235-0026), and N-3 (OMB Control No. 3235-0316) were adopted pursuant to section 8(a) of the Investment Company Act [15 U.S.C. 80a-8] and section 5 of the Securities Act [15 U.S.C. 77e]. Rule 0-1 was adopted pursuant to section 38(a) of the Investment Company Act [15 U.S.C. 80a-37(a)]. Rule 20a-1 (OMB Control No. 3235-0158) and rule 30e-1 (OMB Control No. 3235-0025) were promulgated under sections 20(a) and 30(e) [15 U.S.C. 80a-20 and 80a-29], respectively, of the Investment Company Act. Rule 31a-2 (OMB Control No. 3235-0179) was adopted under sections 31 [15 U.S.C. 80a-30] and 38(a) of the Investment Company Act. Rule 32a-4 (Control No. 3235-0530) was adopted under sections 6(c) [15 U.S.C. 80a-6(c)] and 38(a) of the Investment Company Act.

An agency may not conduct or sponsor, and a person is not required to respond to, a collection of information unless it displays a currently valid control number. Compliance with the disclosure requirements is mandatory. Responses to the disclosure requirements will not be kept confidential.

VII. Summary of Final Regulatory Flexibility Analysis

A Final Regulatory Flexibility Analysis (“FRFA”) has been prepared in accordance with 5 U.S.C. 604. The Commission proposed new rules 2a19-3, 10e-1 and 32a-4, and amendments to rules 0-1, 2a19-1, 10f-3, 12b-1, 15a-4, 17a-7, 17a-8, 17d-1, 17e-1, 17g-1, 18f-3, 23c-3, 30d-1, 30d-2, and 31a-2, and requested comments on the new rules and amendments in the Proposing Release. The Commission prepared an Initial Regulatory Flexibility Analysis (“IRFA”) in accordance with 5 U.S.C. 603 in conjunction with the Proposing Release, which was made available to the public. The Proposing Release summarized the IRFA and solicited comments on it. No comments specifically addressed the IRFA.

A. Need for the Rules and Rule Amendments

1. Amendments to Exemptive Rules

Fund boards of directors have significant responsibilities to protect investors under state law, the Investment Company Act, and many of our rules. Independent directors, in particular, represent the interests of fund shareholders. They serve as “independent watchdogs,” guarding investor interests. We are amending certain Exemptive Rules to require that, for funds relying on those rules:

• Independent directors constitute a majority of the fund's board of directors;

• Independent directors select and nominate other independent directors; and

• Any legal counsel for the fund's independent directors be an “independent legal counsel.”

162

In connection with the adoption of this requirement, we also are defining the term “independent legal counsel.”

We also are adopting rules and rule amendments that will prevent qualified individuals from being unnecessarily disqualified from serving as independent directors, protect independent directors from the costs of legal disputes with fund management, permit us to monitor the independence of directors by requiring funds to keep records of their assessments of director independence, and temporarily suspend the independent director minimum percentage requirements if a fund falls below the required percentage due to an independent director's death or resignation. In addition, we are exempting funds from the requirement that shareholders ratify or reject the directors' selection of an independent public accountant, if the fund

establishes an audit committee composed entirely of independent directors.

2. Disclosure Requirements

In reevaluating our current disclosure requirements about fund directors, we concluded that, while our fundamental approach has been sound, there are several gaps in the information that shareholders currently receive about directors. We are, therefore, requiring that funds provide better information about directors, including:

• Basic information about the identity and business experience of directors;

• Fund shares owned by directors;

• Information about directors that may raise conflict of interest concerns; and

• The board's role in governing the fund.

B. Significant Issues Raised by Public Comment

The Commission requested comment on the IRFA, but we received no comments specifically addressing the analysis. Several commenters, however, asserted that the financial costs of the amendments to the rules under the Act would have a greater impact on funds that are small entities. Those commenters did not, however, provide an estimate of the costs to small entities. A few commenters stated that the disclosure amendments, as proposed, would disadvantage smaller funds.

Two commenters argued that the proposed fund ownership disclosure would disadvantage directors of smaller funds as these funds are more likely to be stand-alone funds or part of a fund complex with fewer funds, thereby reducing the likelihood that such funds would meet directors' particular investment objectives. We have addressed this concern by modifying the proposal to require that funds disclose each director's ownership in each fund that he oversees and each director's aggregate ownership in any funds that he oversees within a his fund family. Although we understand that directors of smaller funds will still have fewer funds from which to choose, limiting fund ownership disclosure to those funds that a director oversees within the same complex should help reduces the disadvantage to directors of smaller funds and still provide investors with information to assess whether a director's interests are aligned with their own..

We also narrowed the scope of immediate family members and related persons in recognition of the overbreadth of our proposal in certain circumstances, which should alleviate concerns that the conflicts of interest disclosure requirements would discourage directors from serving on fund boards.

C. Small Entities Subject to the Rules

As of December 1999, approximately 299 funds met the Commission's definition of small entity for purposes of the Investment Company Act.

163

We note that few, if any, insurance company separate accounts registered on Form N-3 have assets of less than $50 million when separate account assets are aggregated with the assets of the sponsoring insurance company.

The amendments to the Exemptive Rules will affect funds, including any small entities that rely on the Exemptive Rules and do not already meet the new conditions to those rules. Although it appears that funds may incur certain costs in complying with those conditions, the Commission does not have a reasonable basis for estimating those costs. Other rule amendments are not expected to have a significant economic impact on funds, including those that are small entities.

D. Projected Reporting, Recordkeeping, and Other Compliance Requirements

1. Investment Company Act Rule Amendments

The amendment to rule 17d-1(d)(7), and new rules 10e-1 and 2a19-3, will not impose any new reporting, recordkeeping or compliance requirements. The amendments to the Exemptive Rules also will not impose any new reporting or recordkeeping requirements, but will impose three new compliance requirements. For funds relying on the Exemptive Rules, the amendments require that: (i) Independent directors constitute a majority of the fund's board of directors; (ii) independent directors select and nominate other independent directors; and (iii) any legal counsel for the fund's independent directors be an independent legal counsel. Although it appears that there may be certain costs to funds, including those that are small entities, associated with complying with these requirements, the Commission does not have a reasonable basis for estimating those costs.

2. Disclosure Amendments

As noted in our Paperwork Reduction Act Analysis, a few commenters argued that we had underestimated the costs of complying with the proposed rules and amendments.

164

In addition, several commenters stated that compliance with the proposed rules and amendments would have a greater impact on small entities. However, none of the commenters provided an estimate of the impact on small entities, and how it would differ from the impact on larger entities.

164

See supra

note and accompanying text.

E. Agency Action to Minimize Effects on Small Entities

1. Investment Company Act Rule Amendments

With respect to the amendments to the rules under the Act, we believe that establishing different requirements that are applicable specifically to small entities is inconsistent with the protection of investors. We also believe that adjusting the new rules and rule amendments to establish different compliance requirements for small entities could undercut the purpose of the changes: to enhance the effectiveness of independent directors of all funds, and thus better enable those directors to fulfill their role of protecting shareholder interests.

2. Disclosure Amendments

With respect to the disclosure requirements, the Commission believes that special compliance or reporting requirements for small entities would not be appropriate or consistent with investor protection. The disclosure amendments give shareholders and the public greater access to information about directors. Different disclosure requirements for small entities, such as reducing the level of disclosure that small entities would have to provide shareholders, would create the risk that shareholders would not receive adequate information about their independent directors. The Commission believes it is important for shareholders and the public to receive this information about directors for all funds, not just for funds that are not considered small entities. Shareholders in small funds should have information about their directors a

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