Role of Independent Directors of Investment Companies
Federal RegisterNov 3, 1999
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SUMMARY: The Commission is publishing for comment proposed 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 at least 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 proposing amendments to our
rules and forms to improve the disclosure that investment companies
provide about their directors. These proposed 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 directors.
DATES: Comments must be received on or before January 28, 2000.
ADDRESSES: Comments should be submitted in triplicate to Jonathan G.
Katz, Secretary, Securities and Exchange Commission, 450 5th Street,
N.W., Washington, D.C. 20549-0609. Comments also may be submitted
electronically at the following E-mail address: [email protected].
All comment letters should refer to File No. S7-23-99; this file number
should be included on the subject line if E-mail is used. Comment
letters will be available for public inspection and copying in the
Commission's Public Reference Room, 450 5th Street, N.W., Washington,
D.C. 20549. Electronically submitted comment letters also will be
posted on the Commission's Internet web site (http://www.sec.gov).
FOR FURTHER INFORMATION CONTACT: For information regarding the proposed
substantive rule amendments, contact Jennifer B. McHugh, Attorney,
Office of Regulatory Policy, (202) 942-0690, or regarding the
disclosure amendments, contact Annette M. Capretta, Senior Counsel, or
Heather A. Seidel, Senior Counsel, Office of Disclosure Regulation,
(202) 942-0721, at the Division of Investment Management, Securities
and Exchange Commission, 450 5th Street, N.W., Washington, D.C. 20549-
0506.
SUPPLEMENTARY INFORMATION: The Securities and Exchange Commission (the
``Commission'') today is proposing for public comment 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], 2a19-1 [17 CFR
270.2a19-1], 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'').
Table of Contents
Executive Summary
I. Background
II. Discussion
A. Enhancing the Independence of Fund Boards of Directors
1. Independent Directors as a Majority of the Board
(a) Proposed Board Composition Requirements
(b) Suspension of Board Composition Requirements
2. Selection and Nomination of Independent Directors
3. Independent Legal Counsel
B. Limits on Coverage of Directors Under Joint Insurance Policies
C. Exemption from Ratification of Independent Public Accountant
Requirement for Funds with Independent Audit Committees
D. Qualification as an Independent Director
1. Affiliation with a Broker-Dealer
2. Ownership of Index Fund Securities
E. Disclosure of Information about Fund Directors
1. Basic Information about Directors
(a) Location of Information
(b) Required Information
2. Ownership of Equity Securities in Fund Complex
3. Conflicts of Interest
(a) Statutory Scheme Governing Conflicts of Interest
(b) Need for Disclosure Changes
(c) General Approach to Disclosure
(d) Specific Disclosure in the Proxy Rules and SAI
4. Board's Role in Fund Governance
5. Separate Disclosure
6. Technical and Conforming Amendments
7. Compliance Date
F. Recordkeeping Regarding Director Independence
G. General Request for Comments
III. Cost-Benefit Analysis
IV. Paperwork Reduction Act
V. Summary of Initial Regulatory Flexibility Analysis
VI. Statutory Authority
Text of Proposed Rules and Forms
Executive Summary
The board of directors of an investment company (``fund'') has
significant responsibilities to protect investors under state law, the
Investment Company Act, and many of our exemptive rules. Independent
directors, in particular, serve as ``independent watchdogs,'' guarding
investor interests. These interests are paramount, for it is investors
who own the funds and for whose benefit they must be operated.
We recently hosted a Roundtable on the Role of Independent
Investment Company Directors, which highlighted the significance of
those directors in protecting the interests of fund shareholders. After
reviewing corporate governance issues and the recommendations of
participants at our Roundtable, we are proposing a number of rule and
form changes to enhance the independence and effectiveness of fund
boards of directors and provide investors with greater information
about fund directors.
First, we are proposing to require that, for funds relying on
certain exemptive rules:
Independent directors constitute either a majority or a
super-majority (two-thirds) 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, we are proposing rules and rule amendments that would:
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
[[Page 59827]]
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 proposing to require funds to provide better
information about directors, including:
Basic information about the identity and business
experience of directors;
Fund shares owned by directors;
Information about directors' potential conflicts of
interest; and
The board's role in governing the fund's operations.
In addition, today we are publishing a companion release that sets
forth the views of the Commission and the Commission's staff on a
number of interpretive matters.\1\ This release provides guidance on
certain discrete issues related to independent directors.
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\1\ Interpretive Matters Concerning Independent Directors of
Investment Companies, Investment Company Act Release No. 24083 (Oct.
14, 1999) [``Interpretive Release''].
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Together, these initiatives 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
Today, millions of Americans rely on mutual funds to save and
invest for their families' futures.\2\ More than 77 million individual
investors own shares of mutual funds, which hold over $5.5 trillion in
assets--an increase of over 580 percent from ten years ago.\3\
Investments in mutual funds are a significant part of retirement plans
and college savings plans, as well as many traditional brokerage
accounts.\4\ Money market funds, which alone have over $1 trillion in
assets,\5\ often serve as a substitute for checking accounts and
provide an important vehicle for cash management for individual
investors as well as many institutions and businesses.\6\ International
and global funds give investors easy access to foreign markets.\7\
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\2\ For simplicity, this release focuses on mutual funds (i.e.,
open-end funds). Our proposed rule amendments, however, would apply
to all management investment companies, except where noted.
\3\ See Investment Company Institute, Mutual Fund Fact Book 3
(1999) [``1999 Mutual Fund Fact Book'']. Total assets of mutual
funds were $5.525 trillion at the end of 1998, compared to $809.4
billion in 1988. In 1998, an estimated 44 percent of U.S. households
owned mutual funds, up from 5.7 percent in 1980 and 24.4 percent in
1988. Id. at 45. As of December 31, 1998, an estimated 77.3 million
individuals owned shares of mutual funds. Id. at 41. At the end of
1998, assets of all funds (open-end funds, closed-end funds, and
unit investment trusts) totaled $5.778 trillion. See id. at 3
(stating that assets of open-end funds totaled $5.525 trillion at
the end of 1998); Lipper Inc., Lipper Closed-End Fund Performance
Analysis 1-2 (Jan 1999) (stating that assets of closed-end funds
totaled $158 billion at the end of 1998); Investment Company
Institute, Release No. 99-36 (stating that assets of unit investment
trusts totaled $94.54 billion at the end of 1998).
\4\ At the end of 1998, assets totaling approximately $1.9
trillion, or 35 percent of all mutual fund assets, were held in
retirement accounts, up from $348 billion at the end of 1991. 1999
Mutual Fund Fact Book, Supra note 3, at 47-48; see also Jennifer
Karchmer, Planning for Retirement Has Given Mutual Fund Assets a
Steady Boost, Bond Buyer, May 24, 1999, at 6.
\5\ At the end of 1998, money market fund assets totaled
approximately $1.352 trillion. See 1999 Mutual Fund Fact Book, supra
note 3, at 4.
\6\ See generally Investment Company Institute, Money Market
Mutual Funds (1990).
\7\ Assets in funds investing primarily in foreign securities
totaled over $448.5 billion at the end of 1998. See Investment
Company Institute, Release No.99-07 (stating that assets of open-end
funds investing primarily in foreign securities totaled $416.5
billion at the end of 1998); Lipper Inc., Lipper Closed-End Fund
Performance Analysis--Fourth Quarter 1998 Report (stating that
assets of closed-end funds investing primarily in foreign securities
totaled $32 billion at the end of 1998).
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Mutual funds are formed as corporations or business trusts under
state law and, like other corporations and trusts, must be operated for
the benefit of their shareholders.\8\ Mutual funds are unique, however,
in that they are ``organized and operated by people whose primary
loyalty and pecuniary interest lie outside the enterprise.'' \9\ As
described below, this ``external management'' of virtually all mutual
funds presents inherent conflicts of interest and potential for abuses.
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\8\ See generally James M. Storey & Thomas M. Clyde, Mutual Fund
Law Handbook Sec. 7.2 (1998); Allan S Mostoff & Oliver P. Adler,
Organizing an Investment Company--Structural Considerations Sec. 2.4
in The Investment Company Regulation Deskbook (Amy L. Goodman ed.,
1997).
\9\ Division of Investment Management, SEC, Protecting
Investors; A Half Century of Investment Company Regulation 251
(``1992 Protecting Investors Report'']; see also 1 Tamar Frankel,
Regulation of Money Managers 10 (1978).
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An investment adviser typically organizes a mutual fund and is
responsible for its day-to-day operations. The adviser generally
provides the seed money, officers, employees, and office space, and
usually selects the initial board of directors. In many cases, the
investment adviser sponsors several funds that share administrative and
distribution systems as part of a ``family of funds.'' As a result of
this extensive involvement, and the general absence of shareholder
activism, investment advisers typically dominate the funds they
advise.\10\
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\10\ See SEC. Report on the Public Policy Implications of
Investment Company Growth, H.R. Rep. No. 2337, 89th Cong., 2d. Sess.
12 127, 148 (1966) [``Public Policy Report''] (stating that funds
generally are formed by their advisers and remain under their
control, and that advisers' influence permeates fund activities);
Wharton School of Finance and Commerce, a Study of Mutual Funds,
H.R. Rep. No. 2274, 87th Cong., 2d Sess. 463 (1962) [``Wharton
Report''] (discussing the dominant position of advisers in the
control of funds and the infrequency with which funds have a
separate existence from their advisers); see also Clarke Randall,
Fiduciary Duties of Investment Company Directors and Management
Companies Under the Investment Company Act of 1940, 31 Okla. L. Rev.
635, 636 (1978) (``The adviser's control and influence over the fund
is very nearly total.''); In the Matter of Steadman Security
Corporation, Investment Company Act Release No. 9830 [1977 Transfer
Binder] Fed. Sec. L. Rep. (CCH) para. 81,243, at n.81 (Jun. 29,
1977) (``[T]he investment adviser almost always controls the
fund.'').
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Investment advisers to mutual funds are generally organized as
corporations, which have their own shareholders. These shareholders may
have an interest in the mutual fund that is quite different from the
interests of the fund's 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. And while fund shareholders might prefer
that advisers use brokers that charge the lowest possible commissions,
advisers might prefer to use brokers that are affiliates of the
adviser. These types of conflicts (and others) resulted in the
pervasive abuses that led Congress in 1940 to enact legislation
regulating the activities of mutual funds.\11\
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\11\ See section 1(b)(2) of the Act [15 U.S.C. 80a-1(b)(2)];
SEC, Report on Investment Trusts and Investment Companies, Part III
(1939); see also Storey & Clyde, supra note 8, at Sec. 2.2 Joseph
F,. Krupsky, The Role of Investment Company Directors, 32 Bus. Law.
1733, 1737-40 (1977); William J. Nutt, A Study of Mutual Fund
Independent Directors, 120 U. PA. L. Rev. 179, 181 (1971).
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The Investment Company Act establishes a comprehensive regulatory
scheme designed to protect fund investors by addressing the conflicts
of interest between funds and their investment advisers or other
affiliated persons. The Act strictly regulates some of the most serious
conflicts. For example, the Act prohibits certain transactions between
a fund and its affiliates, including the investment adviser, unless
approved by the
[[Page 59828]]
Commission.\12\ The Act also relies on fund boards of directors to
police conflicts of interest.
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\12\ Section 17(a) of the Act [15 U.S.C. 80a-17(a)].
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Under state law, directors are generally responsible for the
oversight of all of the operations of a mutual fund.\13\ In addition,
the Investment Company Act assigns many specific responsibilities to
fund boards. For example, fund boards must evaluate and approve a
fund's advisory contract and any assignment of the contract, and may
unilaterally terminate the contract.\14\ Directors also approve the
fund's principal underwriting contract,\15\ select the fund's
independent accountant,\16\ and value certain securities held by the
fund.\17\ In addition, under the Act and our rules, directors have
responsibility for evaluating the reasonableness of advisory and
distribution-related fees charged the fund \18\ and managing certain
operational conflicts. Just recently, for example, we clarified that
boards must assume oversight responsibility for personal securities
transactions by employees of the fund and its adviser.\19\
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\13\ See Jean Gleason Stromberg, Governance of Investment
Companies, in The Investment Company Regulation Deskbook
Secs. 4.1-.2 (Amy L. Goodman, ed. 1997).
\14\ See section 15(a) of the Act [15 U.S.C. 80a-15a)]
(requiring annual approval of the advisory contract by the funds's
board of directors or shreholders and requiring that the contract
empower the board to terminate the contract); section 15(c) of the
Act [15 U.S.C. 80a-15(c)] (requiring that a fund's independent
directors separately evaluate and approve any advisory contract with
the fund).
\15\ See Section 15(b) of the Act [15 U.S.C. 80a-15(b)]
(requiring approval of the principal underwriting contract by the
fund's board or shareholders); section 15(c) of the Act (requiring
that a fund's independent directors separately evaluate and approve
the fund's contract with its principal underwriter).
\16\ See section 32(a)(1) of the Act [15 U.S.C. 80a-31(a)(1)]
(requiring that a fund's independent directors select the fund's
independent public accountant).
\17\ See section 2(a)(41) of the Act [15 U.S.C. 80a-2(a)(41)]
(requiring, in effect, that any security for which no market
quotation is readily available be valued at fair value as determined
in good faith by the board of directors).
\18\ See sections 15 (a)-(c) of the Act (board review of fees
paid to a fund's adviser and principal underwriter); rule 12b-1
under the Act [17 CFR 270.12b-1] (board review of asset-based
distribution fees paid pursuant to a ``rule 12b-1 plan'').
\19\ See Personal Investment Activities of Investment Company
Personnel, Investment Company Act Release No. 23958 (Aug. 20, 1999)
[64 FR 46821 (Aug. 27, 1999)] (adopting amendments to rule 17j-1
under the Act [17 CFR 270.17j-1]).
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The Act requires that independent directors constitute at least 40
percent of a fund's board,\20\ and sets the standards for when a person
will be disqualified from being an independent director (i.e., will be
considered an ``interested person'' under the Act).\21\ These
independent directors play an important role in representing and
guarding the interests of investors. As has been stated many times,
Congress intended these directors to be the ``independent watchdogs''
\22\ for investors and to ``supply an independent check on
management.'' \23\
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\20\ Section 10(a) of the Act [15 U.S.C. 80a-10(a)] (prohibiting
more than 60 percent of a fund's directors from being interested
persons of the fund). We refer to directors who are not ``interested
persons'' of the fund as ``independent directors.'' See also section
10(b)(2) of the Act [15 U.S.C. 80a-10(b)(2)] (requiring, in effect,
that independent directors comprise a majority of a fund's board if
the fund's principal underwriter is an affiliate of the fund's
investment adviser); section 15(f)(1) of the Act [15 U.S.C. 80a-
15(f)(1)] (providing a safe harbor for the sale of an advisory
business if directors who are not interested persons of the
investment adviser constitute at least 75 percent of a fund's board
for at least three years following the assignment of the advisory
contract).
\21\ Section 2(a)(19) of the Act [15 U.S.C. 80a-2(a)(19)]
(defining ``interested person''); see infra note 170 (discussing the
elements of the definition of ``interested person'').
\22\ See Burks v. Lasker, 441 U.S. 471, 484 (1979) (quoting
Tannenbaum v. Zeller, 552 F.2d 402, 406 (2d Cir. 1977)).
\23\ S. Rep. No. 184, 91st Cong., 2d Sess. 31 (1969).
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Many requirements of the Act and our rules that protect investors
from conflicts of interest specifically rely on action by these
independent directors. The Act, for example, requires independent
directors to separately evaluate and approve the fund's contract with
an investment adviser or principal underwriter.\24\ Our rules have
permitted innovative types of funds, more efficient fund operations,
and new distribution arrangements by exempting funds from prohibitions
related to conflicts of interest. While these rules have provided
important flexibility to allow mutual funds to meet the changing needs
of investors, they also rely on approval, oversight, and monitoring by
independent directors to protect investors.\25\
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\24\See section 15(c) of the Act.
\25\See, e.g., rule 10f-3 [17 CFR 270.10f-3] (permitting funds
to purchase securities in a primary offering when an affiliated
broker-dealer is a member of the underwriting syndicate if the
fund's board, including a majority of its independent directors, (i)
approves procedures regulating purchases of these securities and
(ii) determines at least quarterly that the purchases complied with
the board-approved procedures). In addition, we have eliminated
certain rule provisions that arguably required directors to ``micro-
manage'' fund operations. See Custody of Investment Company Assets
Outside the United States, Investment Company Act Release No. 22658
(May 12, 1997) [62 FR 26923 (May 16, 1997)] (amending rule 17f-5 to
permit fund directors to delegate certain responsibilities related
to foreign custody arrangements and eliminating the requirement that
directors annually review those arrangements); Revision of Certain
Annual Review Requirements of Investment Company Boards of
Directors, Investment Company Act Release No. 19719 (Sept. 17, 1993)
[58 FR 49919 (Sept. 24, 1993)] (eliminating certain annual board
review requirements of rules 10f-3, 17a-7, 17e-1, 17f-4, and 22c-1).
See also Investment Company Institute, SEC No-Action Letter (Jun.
15, 1999) (revising the staff's previous position to permit a fund's
adviser, rather than the fund's board, to evaluate the
creditworthiness of repurchase agreement counterparties and
otherwise assume primary responsibility for monitoring and
evaluating the fund's use of repurchase agreements).
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Earlier this year we held a two-day public Roundtable discussion on
the role of independent directors of mutual funds.\26\ Participants in
the Roundtable included independent directors, investor advocates,
executives of fund advisers, academics, corporate governance experts,
and experienced legal counsel. They examined the activities and
responsibilities of independent directors and reviewed the nature of
their independence. Participants also discussed various ways that the
Commission might promote greater effectiveness of independent
directors.
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\26\ See SEC, Notice of Sunshine Act Meetings (Feb. 18, 1999)
[64 FR 8632 (Feb. 22, 1999)]; see also Transcripts from the
Roundtable on the Role of Independent Investment Company Directors,
February 23-24, 1999 [``Roundtable Transcripts'']. The Roundtable
Transcripts are available to the public in the Commission's public
reference room and the Commission's Louis Loss Library. They also
are available on the Commission's Internet web site http://
www.sec.gov/offices/invmgmt/roundtab.htm>.
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We endorse the sentiments of the Roundtable participants who favor
enhancing the effectiveness and independence of fund boards of
directors. While those sentiments can be fully achieved only through
amendments to the Investment Company Act, we are impressed by the
consensus of the participants concerning the importance of the role of
independent directors and the conditions they believe are necessary to
enhance the effectiveness of those directors. We therefore are
proposing rule amendments 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.
II. Discussion
A. Enhancing the Independence of Fund Boards of Directors
Panelists at our recent Roundtable discussed a number of possible
ways to enhance the independence and effectiveness of fund boards. Most
participants agreed that independent directors can best fulfill their
responsibilities when they constitute a substantial majority of the
board.
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Participants also recommended that the selection of new independent
directors be entrusted to existing independent directors and that
independent directors have independent legal counsel.\27\ An industry
advisory group organized by the Investment Company Institute recently
made similar recommendations in a ``best practices'' report (``ICI
Advisory Group Report'').\28\
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\27\ See infra notes 41, 63, and 76 (citing testimony of
Roundtable participants). We discuss the merits of each of these
recommendations below.
\28\ Investment Company Institute, Report of the Advisory Group
on Best Practices for Fund Directors: Enhancing A Culture of
Independence and Effectiveness (June 24, 1999). On July 7, 1999, the
Board of Governors of the Investment Company Institute unanimously
endorsed the recommended ``best practices.'' See ``ICI Board Adopts
Resolution Urging Fund Industry to Strengthen Governance,'' at
http://www.ici.org/issues/dtrs__best__prac.htm>.
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The recommendations of the Roundtable participants have led us to
review our exemptive rules that provide funds and advisers relief from
various statutory prohibitions designed to prevent the most egregious
conflicts of interest. Roundtable participants repeatedly noted that
one of the most important functions of independent directors is to
oversee conflicts of interest.\29\ Although the rules that we have
adopted over the years have expanded the responsibilities of boards,
the rules generally do not contain conditions designed to enhance the
independence and effectiveness of fund boards, with two notable
exceptions.\30\
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\29\ See, e.g., Roundtable Transcript of Feb. 24, 1999 at 174
(statement of John C. Coffee, Jr.) (stating that the need for
activism by independent directors is most evident in the context of
conflicts of interest); id. at 197 (statement of Richard M.
Phillips) (``[T]he focal point of independent directors is conflicts
of interest.'').
\30\ Rule 12b-1, one of the exceptions, permits the use of fund
assets to pay for distribution of fund shares, but only if the
fund's independent directors select and nominate other independent
directors. See rule 12b-1(c) under the Act [17 CFR 270.12b-1(c)]. In
adopting this requirement, we stated our view that ``as a general
proposition disinterested directors should not be entrusted with a
decision on the use of fund assets for distribution without
receiving the benefit of measures designed to enhance their ability
to act independently.'' Bearing of Distribution Expenses by Mutual
Funds, Investment Company Act Release No. 11414 (Oct. 28, 1980) [45
FR 73898 (Nov. 7, 1980)] [''Rule 12b-1 Adopting Release''], at text
following n.50. Rule 23c-3, the other exception, permits the
creation of so-called ``interval funds'' (i.e., closed-end funds
that periodically offer to repurchase their securities from
investors), but only if independent directors constitute a majority
of the board, and select and nominate other independent directors.
Rule 23c-3(b)(8) under the Act [17 CFR 270.23c-3(b)(8)]. These
requirements were included in the rule to ``ensure that the board of
directors provides independent decisions or scrutiny for actions or
decisions that may involve a conflict of interest between the
adviser and [the fund's] shareholders.'' Repurchase Offers by
Closed-End Management Investment Companies, Investment Company Act
Release No. 19399 (Apr. 7, 1993) [58 FR 19330 (Apr. 14, 1993)]
[``Rule 23c-3 Adopting Release''], at Section II.D.
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Upon reflection, and in light of the recommendations of the
Roundtable participants, we believe that our exemptive rules that rely
on fund boards to approve and oversee arrangements or transactions that
involve conflicts of interest and are otherwise prohibited by the Act
also should contain provisions designed to enhance director
independence and effectiveness. We therefore are proposing amendments
to certain exemptive rules under the Investment Company Act to enhance
the independence of fund directors who are charged with overseeing the
fund's activities and transactions covered by those rules. These
amendments would require, for funds that rely (or whose affiliated
persons rely) on the rules, that: (i) independent directors constitute
either a majority or a super-majority (two-thirds) of their boards;
(ii) independent directors select and nominate other independent
directors; and (iii) any legal counsel for the independent directors be
an independent legal counsel.
Our proposals to enhance board independence would amend ten rules
under the Investment Company Act. We have selected those rules that (i)
exempt funds or their affiliated persons from provisions of the Act,
and (ii) have as a condition the approval or oversight of independent
directors. For convenience, we will refer to these rules as the
``Exemptive Rules.'' \31\ The Exemptive Rules typically relieve funds
from statutory prohibitions that preclude certain types of transactions
or arrangements that would involve serious conflicts of interest.\32\
In one case, a rule permits the board to approve an interim advisory
agreement without a shareholder vote that otherwise would be
required.\33\ Based on these criteria, we propose to amend the
following rules:
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\31\ A number of the Exemptive Rules exempt fund affiliates,
rather than the fund, from certain statutory prohibitions. For ease
of reference, this Release generally refers to funds that rely on
the Exemptive Rules, rather than reiterating that funds or their
affiliated persons may be relying on the rules.
\32\ These rules also require boards of funds relying on the
rules to exercise vigilance in protecting funds and their investors.
See, e.g., Exemption for the Acquisition of Securities During the
Existence of an Underwriting or Selling Syndicate, Investment
Company Act Release No. 22775 (July 31, 1997) [62 FR 42401 (Aug. 7,
1997)], at n.52 and accompanying text (the fund's board should be
``vigilant'' not only in reviewing the fund's compliance with the
procedures required by rule 10f-3, but also ``in conducting any
additional reviews that it determines are needed to protect the
interests of investors'').
\33\ See rule 15a-4 [17 CFR 270.15a-4]. Under section 15(a) of
the Act, shareholders generally must approve a fund's contract with
its adviser.
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Rule 10f-3 (permitting funds to purchase securities in a
primary offering when an affiliated broker-dealer is a member of the
underwriting syndicate);
Rule 12b-1 (permitting use of fund assets to pay
distribution expenses);
Rule 15a-4 (permitting fund boards to approve interim
advisory contracts without shareholder approval);
Rule 17a-7 (permitting securities transactions between a
fund and another client of the fund's adviser);
Rule 17a-8 (permitting mergers between certain affiliated
funds);
Rule 17d-1(d)(7) (permitting funds and their affiliates to
purchase joint liability insurance policies);
Rule 17e-1 (specifying conditions under which funds may
pay commissions to affiliated brokers in connection with the sale of
securities on an exchange);
Rule 17g-1(j) (permitting funds to maintain joint insured
bonds);
Rule 18f-3 (permitting funds to issue multiple classes of
voting stock); and
Rule 23c-3 (permitting the operation of interval funds by
enabling closed-end funds to repurchase their shares from investors).
The Commission requests comment on the criteria that we have used
to select these rules. Are there additional rules that we should
similarly amend? Conversely, should any of the Exemptive Rules not be
amended?
Although the Commission urges all funds to adopt these measures to
strengthen the independence of their boards, we are not proposing to
require all funds to adopt these measures. Funds that do not rely on
any of the Exemptive Rules will not be subject to these requirements.
They may continue, for example, to have only 40 percent of their boards
consist of independent directors.
As discussed above, an advisory group organized by the Investment
Company Institute (``ICI Advisory Group'') has issued a report
containing a set of ``best practices'' for ``enhancing a culture of
independence and effectiveness'' of fund directors.\34\ These best
practices generally include some of the practices that our proposed
rule amendments would require boards to adopt in order to rely on the
Exemptive Rules. We applaud the initiative, but, as the report
acknowledges, many of the ``best practices'' may be impracticable or
unnecessary for all funds to adopt. Moreover, it may not be appropriate
for us to address many of the
[[Page 59830]]
recommendations through rulemaking.\35\ Thus, we are not at this time
proposing to require that funds relying on the Exemptive Rules follow
all of these practices. Nonetheless, we believe that fund boards should
give serious consideration to the recommendations of the ICI Advisory
Group. We request comment whether we should amend the Exemptive Rules,
or other rules, to require funds relying on them to follow any of these
``best practices.'' Commenters who favor any of these practices also
should address the benefits and burdens of amending the Exemptive Rules
in this manner.
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\34\ ICI Advisory Group Report, supra note 28.
\35\ In addition, because our rules apply to all funds (or, in
the case of the Exemptive Rules, all funds that rely on those
rules), we have designed our amendments by considering, among other
things, the costs, benefits, and paperwork burdens for funds and
investors (including small entities) that may result from the
changes. See, e.g., infra Section III (cost-benefit analysis);
Section IV (Paperwork Reduction Act analysis); Section V (Regulatory
Flexibility Act analysis). In each area of consideration, we have
requested comment on the costs, benefits, and burdens of the
proposed rule amendments.
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1. Independent Directors as a Majority of the Board
(a) Proposed Board Composition Requirements. We believe that a fund
board that has at least a majority of independent directors is better
equipped to perform its responsibilities of monitoring potential
conflicts of interests and protecting the fund and its
shareholders.\36\ By virtue of its independence, and its ability to act
without the approval of the investment adviser (whose employees often
serve as interested, or ``inside,'' directors on fund boards), such a
board is better able to exert a strong and independent influence over
fund management.\37\ This is particularly important in circumstances
where the fund's interests conflict with those of the adviser.\38\
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\36\ See 1992 Protecting Investors Report, supra note 9, at 267
(``[A]n increased measure of independence is necessary to allow
independent directors to perform these responsibilities
appropriately.''). In the context of business development companies,
Congress has recognized that having a majority of independent
directors is particularly important ``where board approval is made
expressly a substitute for Commission review or for a per se
restriction.'' H.R. Rep. No. 1341, 96th Cong., 2d Sess. 25 (1980).
See also S. Rep. No. 75, 94th Cong., 1st Sess. 71 (1975) (stating
that the requirement in section 15(f) that 75 percent of a fund's
board consist of directors who are not interested persons of the
adviser for three years following the sale of an advisory contract
is a ``safeguard [ ] to protect the investment company and its
shareholders'').
\37\ The original Senate bill that culminated in the Investment
Company Act would have required a majority of a fund's directors to
be independent from management. See S. 3580, 76th Cong., 3d Sess.
Sec. 10(a) (1940). That requirement was changed to 40 percent out of
concern that a board with an independent majority would repudiate
the recommendations of the investment adviser, depriving fund
shareholders of those recommendations. See Investment Trusts and
Investment Companies: Hearings on H.R. 10065 Before the House
Subcomm. on Interstate and Foreign Commerce, 76th Cong., 3d Sess.
109-10 (1940) (statement of David Schenker). Experience has shown
that this concern was unfounded. See 1992 Protecting Investors
Report, supra note 9, at 267. Rather, we believe that an independent
majority enhances board oversight without unnecessarily impeding
fund operations or significantly increasing costs.
\38\ We expressly recognized this when we adopted rule 23c-3. We
included the requirements that independent directors constitute a
majority of the board and select and nominate their successors to
``ensure that the board of directors provides independent decisions
or scrutiny for actions or decisions that may involve a conflict of
interest between the adviser and [fund] shareholders.'' Rule 23c-3
Adopting Release, supra note 30; cf. Peter Tufano & Matthew Sevick,
Board Structure and Fee-setting in the U.S. Mutual Fund Industry, J.
FiN. ECON. 321, 350 (1997) (``[T]he salutary benefits of * * * a
higher fraction of independent directors [on a fund's board] should
be most visible when management's and shareholders' interests are
most at odds.'').
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Today most, but not all, mutual funds have boards with at least a
simple majority of independent directors.\39\ When our Division of
Investment Management studied mutual fund governance in 1992 it
recommended that, as a requirement for all funds, independent directors
constitute at least a majority of a fund's board.\40\ Many of the
Roundtable participants stated that, based on their experience, a fund
board generally is more effective if independent directors represent a
substantial majority of the board.\41\ Similarly, the ICI Advisory
Group Report recently endorsed boards having a ``super-majority'' of
independent directors. The Report concluded that a two-thirds majority
of independent directors on a board ``will be more effective than a
simple majority in enhancing the authority of independent
directors.''\42\
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\39\ See ICI Advisory Group Report, supra note 28, at 5 (``The
vast majority of fund boards today consist of a majority of
independent directors.''); Investment Company Institute,
Understanding the Role of Mutual Fund Directors 5 (1998) (noting
that most fund boards have a majority of independent directors). In
some cases, fund boards have an independent majority in order to
comply with certain requirements of the Act and our rules. See,
e.g., section 10(b)(2) (requiring, in effect, that independent
directors comprise a majority of a fund's board if the fund's
principal underwriter is an affiliate of the fund's investment
adviser); section 15(f)(1) (providing a safe harbor for the sale of
an advisory business if directors independent of the adviser
constitute at least 75 percent of a fund's board for at least three
years following the assignment of the advisory contract); rule 6e-
3(T)(b)(15) [17 CFR 270.6e-3(T)(b)(15)] (exempting certain funds
underlying insurance products from various Investment Company Act
provisions provided that independent directors constitute a majority
of the boards of those funds); rule 23c-3(b)(8) (permitting the
operation of interval funds if, among other conditions, independent
directors comprise a majority of the board).
\40\ See 1992 Protecting Investors Report, supra note 9, at 267
(Division recommended that Investment Company Act be amended to
require that independent directors constitute more than 50 percent
of a fund's board); see also Wharton Report, supra note 10, at 35
(increasing the proportion of unaffiliated directors may enhance the
value of those directors as a check on management).
\41\ See Roundtable Transcript of Feb. 24, 1999 at 241
(statement of Aulana L. Peters) (``My experience * * * dictates that
for a board to have a chance of operating truly independently * * *
there should be at least two independent [ ] [directors] to one
[inside director].''); id. at 265 (statement of Gerald C. McDonough)
(recommending that fund boards be required to have ``a certain
majority, 60, 66 percent, * * * certainly a clear majority of truly
independent [directors]''); Roundtable Transcript of Feb. 23, 1999
at 136 (statement of Faith Colish) (endorsing a ``substantial
majority'' of independent directors as a positive corporate
governance feature for fund boards). See also Tufano & Sevick, supra
note 38 (using empirical analysis to suggest that funds with boards
that have a larger fraction of independent directors tend to have
lower fees).
\42\ See ICI Advisory Group Report, supra note 28, at 11.
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We take the conclusions of the ICI Report as a serious
recommendation reflecting the collective experience and wisdom of the
Advisory Group, which consisted of prominent members of the mutual fund
industry.\43\ Although the Report did not address whether Congress or
the Commission should adopt a two-thirds majority as a regulatory
requirement, it recommended the standard as a ``best practice'' for all
funds to consider.\44\ It is unclear, however, why a super-majority
standard as a ``best practice'' would be appropriate for some fund
boards and not others.
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\43\ As noted above, the Board of Governors of the ICI also
unanimously endorsed the recommendations of the ICI Advisory Group
Report. See supra note 28.
\44\ The Report also noted that, while many funds already have a
two-thirds majority of independent directors, the practice is ``far
from universal.'' ICI Advisory Group Report, supra note 28, at 11.
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A simple majority requirement would permit, under state law, the
independent directors to control the ``corporate machinery,'' i.e., to
elect officers of the fund, call meetings, solicit proxies, and take
other actions without the consent of the adviser. Such a provision
would require few funds to change the current composition of their
boards, but would bring those that must change into conformity with the
better practice. A two-thirds requirement, on the other hand, could
change the dynamics of board decision-making in favor of the interests
of investors, but may require many funds to change the composition of
their boards.
In light of the potential benefits to funds, their boards, and
shareholders, we are proposing to amend the Exemptive Rules to require
funds relying on them to have boards with at
[[Page 59831]]
least a majority of independent directors. Comment is requested on
whether we should adopt a simple majority requirement, as the staff
recommended in 1992, or the two-thirds super-majority requirement
recommended by the ICI Advisory Group Report. We also request comment
whether we should adopt an even higher percentage requirement (e.g., 75
percent or 100 percent).\45\
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\45\ See, e.g., section 15(f)(1) of the Act (providing a safe
harbor for the sale of an advisory business if directors who are
independent of the adviser constitute at least 75 percent of a
fund's board for at least three years following the assignment of
the advisory contract). The ICI Advisory Group Report discussed, but
did not recommend at a best practice, having fund boards comprised
exclusively of independent directors. See ICI Advisory Group Report,
supra note 28, at 11-12. As a result of the Glass-Steagall Act, most
bank-sponsored funds have boards comprised entirely of independent
directors. See section 32 of the Glass Steagall Act [12 U.S.C. 78]
(prohibiting directors of any entity issuing securities, such as a
fund, from simultaneously serving as an officer, director, or
employee of a national bank); see also Roundtable Transcript of Feb.
24, 1999 at 111 (statement of Richard J. Herring, independent
director of a family of bank-related mutual funds and business
school professor of international banking) (noting that a bank-
related fund board comprised entirely on independent directors
``works quite well'').
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We note that the charters \46\ of some funds may contain provisions
that require the approval of greater than a majority of a fund's board
for some matters, and, in light of our proposed amendments, other funds
may amend their charters to provide that a board may act only upon the
vote of greater than a simple (or two-thirds) majority of its members.
Would the existence of these super-majority voting provisions in fund
charters undercut the effectiveness of a board with a majority of
independent directors by requiring the consent of the ``inside''
directors and thus, in many cases, give the adviser a veto over board
votes? We request comment regarding the prevalence and potential effect
of these voting provisions in fund charters.
---------------------------------------------------------------------------
\46\ We use the term ``charters'' generally to include the
organizational documents of a fund--typically articles of
incorporation or declarations of trust, and corporate by-laws.
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If we adopt the proposed amendments, we expect to delay the
compliance date for one year to allow funds to bring their boards into
compliance with the majority independence condition to the Exemptive
Rules.\47\ As of the compliance date, any fund relying on an Exemptive
Rule would be required to have a board with the requisite percentage of
independent directors. We request comment on this transition period.
---------------------------------------------------------------------------
\47\ There are several methods by which funds could affect the
transition to majority independent representation on their boards.
For instance, funds could (i) increase the size of their boards and
elect new independent board members; (ii) decrease the size of their
boards and allow some inside directors to resign; or (ii) allow some
inside directors to resign and replace them with independent board
members. A fund's ability to alter the composition of its board
without holding a shareholder vote will be determined by state law
and by section 16(a) of the Act [15 U.S.C. 89a-16(a)], which states
that a fund's board may fill a board vacancy without a shareholder
vote if, after the new director takes officer, at least two-thirds
of the board has been elected by shareholders. Section 16(a) further
requires a shareholder meeting to elect directors if the number of
shareholder-elected board members decreases to less than half of the
board. Newly organized funds could begin operations during the one-
year transition period without a majority of independent directors
and still rely on the Exemptive Rules, but they, like other funds,
would be required to have boards with a majority of independent
directors if they rely on any of the Exemptive Rules after the
compliance date for the amendments.
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(b) Suspension of Board Composition Requirements. 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 under the Investment Company Act, section 10(e) of
the Act suspends the percentage requirement for a short time to allow
the vacancy to be filled.\48\ Under section 10(e), the relevant
percentage requirement is suspended for 30 days if the board may fill
the vacancy,\49\ or for 60 days if the vacancy must be filled by a
shareholder vote.\50\ Section 10(e) also authorizes the Commission to
set a longer period for filling a board vacancy in these
circumstances.\51\
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\48\ Various provisions of the Investment Company Act require a
particular percentage or minimum number of independent directors.
See sections 10(a), 10(b)(2), 10(d) [15 U.S.C. 80a-10(d)], and
15(f)(1); see also supra notes 20, 39, and 45 (discussing sections
10(a), 10(b)(2), and 15(f)(1) and their percentage requirements).
Section 10(e) [15 U.S.C. 80a-10(e)] similarly suspends the board
composition requirements of sections 10(d)(1), 10(b)(3), and 10(c)
[15 U.S.C. 80a-10(b)(1), -10(b)(3), and -10(c)]. For convenience, we
refer to all of the above requirements as ``percentage
requirements.''
\49\ See section 16(a) of the Act (permitting directors to fill
a board vacancy if, after the new director takes officer, at least
two-thirds of the board has been elected by shareholders, but
requiring a shareholder meeting to elect directors if the number of
shareholder-elected board members decreases to less then half of the
board).
\50\ Section 10(e)(1) and (2) [15 U.S.C. 80a-10(e)(1) and (2)].
\51\ Section 10(e)(3) [15 U.S.C. 80a-10(e)(3)].
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In our experience, the time provided by section 10(e) is
insufficient for most funds to select and nominate qualified
independent director candidates, and, if necessary, hold a shareholder
election. Many funds address this problem by avoiding the need to rely
on the section--they have a greater percentage of independent directors
than is required by the Act. This approach may become more difficult
if, as we propose, funds relying on the Exemptive Rules must have a
majority or a super-majority of independent directors.\52\ Moreover,
the consequence of a fund falling below the minimum required percentage
of independent directors would be more severe and more immediate
because the fund would lose the availability of the Exemptive
Rules.\53\
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\52\ See supra Section II.A.1.a.
\53\ Currently, the loss of an independent director that causes
a fund to fall below a statutorily required percentage of
independent directors does not result in immediate consequences for
a fund. Issues arise only when the fund's next board vote is
required. Under the proposed amendments to the Exemptive Rules,
however, the fund would be unable, for example, to offer multiple
classes of shares, pay distribution fees under rule 12b-1, engage in
securities transactions with fund affiliates, or participate in a
joint liability insurance policy from the date of the loss of the
independent director until the fund replaces the independent
director.
---------------------------------------------------------------------------
The Commission is proposing new rule 10e-1 to address these
concerns. Proposed rule 10e-1 would suspend the board composition
requirements of the Act, and of the rules under the Act, for 60 days if
the board of directors may fill the vacancy or 150 days if a
shareholder vote is required.\54\ We believe these longer time periods
are appropriate in light of the need to select, nominate, and elect
qualified candidates for service as independent directors.\55\
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\54\ See proposed rule 10e-1.
\55\ See infra Section II.A.2 (discussing the selection and
nomination of independent directors by other independent directors);
cf. Temporary Exemption for Certain Investment Advisers, Investment
Company Act Release No. 23325 (July 22, 1998) [63 FR 40231 (July 28,
1998)] (proposing amendments to rule 15a-4 in part to extend, from
120 days to 150 days, the period of time funds are permitted to
operate with an interim advisory contract that has not been approved
by shareholders to allow funds more time to seek shareholder
approval of an advisory contract).
---------------------------------------------------------------------------
We request comment whether the proposed 60-day and 150-day periods
are adequate to provide funds and their independent directors with the
time needed to approve new independent directors. Commenters who
believe that a longer or shorter period is appropriate should explain
why, and specify the number of days they believe would be adequate.
2. Selection and Nomination of Independent Directors
Independent directors who are truly independent are more effective
in their roles as ``watchdogs'' for fund shareholders. While the
Investment Company Act precludes independent directors from having
certain affiliations or relationships with the fund's adviser or
principal underwriter,\56\ no law can
[[Page 59832]]
guarantee that an independent director will be vigilant in protecting
fund shareholders. Fund shareholders therefore must depend on the
character, ability, and diligence of persons who serve as fund
directors to protect their interests.\57\
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\56\ See section 2(a)(19)(B) [15 U.S.C. 80a-2(a)(19)(B)]
(outlining the types of affiliations and relationships that render a
director an ``interested person'' of a fund's adviser or principal
underwriter).
\57\ See Bearing of Distribution Expenses by Mutual Funds,
Investment Company Act Release No. 10862 (Sept. 7, 1979) [44 FR
54014 (Sept. 17, 1979)] (proposing rule 12b-1) (``[P]roper
fulfillment of directors' duties depends primarily on the character,
ability, and diligence of directors.''); William G. Bowen, Inside
the Boardroom: Governance by Directors and Trustees 47 (1994)
(``Effective governance by any board surely depends, most of all, on
having an outstanding group of members.''); Roundtable Transcript of
Feb. 23, 1999 at 14-15 (statement of Arthur Levitt, Chairman, SEC)
(``[B]oard independence does not come from a specific legal
structure * * * I believe passionately in boards made up of men and
women of good, sound independent judgment. Board independence comes
from directors who do their jobs aggressively.'').
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One recognized method of enhancing the independence of directors is
to commit the selection and nomination of new independent directors to
the incumbent independent directors.\58\ Independent directors who are
selected and nominated by other independent directors, rather than by
the fund's adviser, are more likely to have their primary loyalty to
shareholders rather than the adviser.\59\ In addition, when independent
directors are self-selecting and self-nominating, they are less likely
to feel beholden to the adviser. Thus, they may be more willing to
challenge the adviser's recommendations when the adviser's interests
conflict with those of the shareholders.\60\
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\58\ Selection and nomination refers to the process by which
board candidates are researched, recruited, considered, and formally
named. Some funds establish a nominating committee of the board that
is comprised entirely of independent directors to select and
nominate directors.
\59\ See ICI Advisory Group Report, supra note 28, at 14
(``[I]ndependent directors are uniquely qualified to evaluate
whether a present or prospective director is likely to contribute to
the continuing independence and effectiveness of the independent
directors as a group.'').
\60\ See ICI Advisory Group Report, supra note 28, at 14
(``[C]ontrol of the nominating process by the independent directors
helps dispel any notion that the directors are `hand picked' by the
adviser and therefore not in a position to function in a true spirit
of independence.'')
---------------------------------------------------------------------------
Two comprehensive studies that addressed mutual fund governance
recognized that the selection and nomination of independent directors
by other independent directors could enhance their independence.\61\ In
its guidebook for fund directors, the American Bar Association's
Section of Business Law has endorsed this practice,\62\ as did several
participants at our Roundtable.\63\ The recent ICI Advisory Group
report also recommended the self-selection and self-nomination of
independent directors.\64\ As noted above, two of our rules currently
require funds to have self-selecting and self-nominating independent
directors,\65\ and many fund groups have adopted this practice.\66\
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\61\ See 1992 Protecting Investors Report, supra note 9, at 266-
67 (recommending that the Act be amended to require that independent
directors be self-nominating); Wharton Report, supra note 10, at
465-66 (noting that the selection of unaffiliated directors by
management limits those directors' independence).
\62\ See A.B.A., Section of Business Law, Fund Director's
Guidebook 27 (1996) [``Fund Director's Guidebook''] (``The
independence of a fund's independent directors is enhanced by
providing that persons nominated by the board for election as
independent directors be nominated by a committee of the fund's
incumbent independent directors.'').
\63\ See Roundtable Transcript of Feb. 24, 1999 at 182
(statement of John C. Coffee, Jr.) (``[W]e should have'' independent
nominating committees.); Roundtable Transcript of Feb. 23, 1999 at
136 (statement of Faith Colish) (``a very good idea''); Roundtable
Transcript of Feb. 24, 1999 at 63 (statement of Dawn-Marie Driscoll)
(``I'm a great believer in independent directors choosing other
independent directors who the adviser does not know. * * * The more
ways you can ensure independence, the better the process will
be.''); id. at 148 (statement of Ronald J. Gilson) (``A nominating
committee made up of independent directors makes an enormous amount
of sense.''); id. at 215 (statement of John R. Haire) (``[Self-
selection and self-nomination are] very helpful in the process of
seeing that * * * independent directors * * * bring to the board a
diversity of skills that are useful * * * in the role of overseeing
management.''); id. at 243 (statement of Aulana L. Peters) (``[I]t
is not a good idea to have the adviser or the CEO of the adviser * *
* be the sole decisionmaker on who should serve as a disinterested
member of the board.''). But see id. at 245 (statement of Aulana L.
Peters) (stating that the involvement of a fund's adviser in the
selection and nomination of independent directors may facilitate
increasing diversity on a fund's board).
\64\ See ICI Advisory Group Report, supra note 28, at 14-16.
\65\ Rule 12b-1 permits the use of fund assets to pay for
distribution of fund shares, but only if the fund's independent
directors select and nominate other independent directors. See supra
note 30 (discussing rule 12b-1). In discussing our decision to
include this condition in the rule, we noted that ``the likelihood
that a decision will be in the best interests of a fund and its
shareholders will be increased if the disinterested directors are
genuinely independent of management,'' and that ``formal
independence will breed an atmosphere in which actual independence
will develop.'' Rule 12b-1 Adopting Release, supra note 30, at
discussion of ``Independence of Directors.'' See also supra note 30
(discussing rule 23c-3, which permits the operation of interval
funds if independent directors are self-selecting, self-nominating,
and comprise a majority of the board). The Act also requires
independent directors to select and nominate individuals to fill
independent director vacancies for a period of three years following
the sale of an investment advisory contract. Section 16(b) [15
U.S.C. 80a-16(b)].
\66\ See ICI Advisory Group Report, supra note 28, at 15 (noting
that funds with rule 12b-1 plans, which are required to have self-
selecting and self-nominating independent directors, represent a
majority of all mutual funds and that many funds without rule 12b-1
plans also assign to independent directors the selection and
nomination of other independent directors); Joel H. Goldberg &
Gregory N. Bressler, Revisiting Rule 12b-1 Under the Investment
Company Act, 31 Rev. Sec. & Commodities Reg. 147, 147 (1998) (since
the adoption of rule 12b-1 in 1980, over 7,000 mutual funds have
adopted rule 12b-1 plans).
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We are proposing to amend each of the Exemptive Rules to require
that funds relying on those rules have boards whose independent
directors select and nominate any other independent directors.\67\
Funds that have adopted distribution plans under rule 12b-1, which
already contains this requirement, would be unaffected by the
proposal.\68\ Funds whose independent directors were not nominated in
this manner would not immediately lose their ability to rely on the
Exemptive Rules. Rather, if we adopt the proposed amendments, these
funds would be required to adopt the practice before the compliance
date for the amendments, and the fund's incumbent independent directors
subsequently would select and nominate all independent directors of the
fund.\69\
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\67\ See proposed rules 10f-3(b)(11)(i); 15a-4(c)(1); 17a-
7(f)(1); 17a-8(c)(1); 17d-1(d)(7)(v)(A); 17e-1(c)(1); 17g-
1(j)(3)(i); 18f-3(e)(1). In addition, we are proposing to amend
rules 12b-1 and 23c-3 to conform their current language regarding
the self-selection and self-nomination of independent directors to
the language of the proposed amendments. Proposed rules 12b-1(c)(1)
and 23c-3(b)(8)(i).
\68\ Our proposals to amend rules 12b-1 and 23c-3 to conform
their language regarding self-selection and self-nomination to the
language of our proposed amendments are not intended to have any
substantive effect on the operation of those rules. See proposed
rules 12b-1(c)(1), 23c-3(b)(8)(i).
\69\ Our proposed amendments would have no impact on the initial
selection of an organizing fund's directors because, at the time of
organization, the fund would not yet be registered under the
Investment Company Act and therefore would not be relying on our
Exemptive Rules. Any organizing fund that intends to rely on the
Exemptive Rules, however, should adopt a self-selection and self-
nomination practice, and once the fund begins operations,
independent directors should select and nominate other independent
directors as board vacancies occur.
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We understand that committing the selection and nomination of
independent directors to a board committee composed entirely of
independent directors might, in some cases, conflict with applicable
state law.\70\ We believe that a fund could comply with our proposed
amendments in those circumstances if the fund's independent directors
choose the candidates and then present their recommendations to the
full board. We
[[Page 59833]]
request comment whether this approach adequately addresses any
potential conflicts between state law and our proposed amendments
regarding self-selection and self-nomination of independent directors.
---------------------------------------------------------------------------
\70\ See, e.g., ICI Advisory Group Report, supra note 28, at
n.28 (discussing Md. Code Ann., Corps. & Ass'ns Sec. 2-411(a)(2),
which prohibits the bylaws of a Maryland corporation from
authorizing the board to delegate to a committee the power to
recommend to stockholders any action that requires stockholder
approval). Section 2-411(a)(2) may have a greater effect on closed-
end funds, which, unlike mutual funds, generally must hold annual
meetings of shareholders at which shareholders elect directors.
---------------------------------------------------------------------------
Moreover, our proposals regarding the self-selection and self-
nomination of independent directors are not intended to limit the
abilities of public shareholders to nominate independent directors. To
the extent permitted under state law, shareholders may participate in
the nomination process.\71\
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\71\ See Item 7(e)(2) of Schedule 14A (requiring that any proxy
sent to shareholders for the purpose of electing directors state
whether a registrant's nominating committee will consider nominees
recommended by shareholders and describe the procedures to be
followed by shareholders submitting nominee recommendations); see
also infra note 224 and accompanying text.
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We request comment whether we should further amend the Exemptive
Rules to require that independent directors, rather than the entire
board, elect other independent directors in those instances when a
shareholder vote is not required.\72\ Commenters should discuss the
effect state law would have on a fund board's ability to delegate its
authority to elect directors to a subset of the board.
---------------------------------------------------------------------------
\72\ The ICI Advisory Group Report recommends that, to the
extent permitted by state law, fund boards delegate to a fund's
incumbent independent directors the authority to elect independent
directors in the absence of a shareholder vote. See Advisory Group
Report, supra note 28, at 15-16; see also supra note 47 (discussing
section 16(a) of the Act and the circumstances under which fund
directors may elect a board member without holding a shareholders
vote).
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3. Independent Legal Counsel
Another recognized method of enhancing the independence and
effectiveness of independent directors is to provide them with
independent counsel.\73\ Because mutual funds are highly regulated and
their boards frequently are called upon to protect fund shareholders
from conflicts of interest, independent counsel can be particularly
helpful to independent directors of funds.\74\ Experienced counsel can
help to identify potential conflicts of interest and other compliance
issues. They can assist directors in ``marshal[ling] arguments to
balance those presented by management in matters involving conflicts of
interest,'' and evaluating legal issues with an independent and
critical eye.\75\ Often, independent counsel can draw on their
experience and knowledge to identify best practices of other funds that
might be appropriate for directors to adopt for their fund.
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\73\ See generally Grover C. Brown, Michael J. Maimone, and
Joseph C. Schoell, Director and Advisor Disinterestedness and
Independence Under Delaware Law, 23 Del. J. Corp. L. 1157 (1998).
\74\ See ICI Advisory Group Report, supra note 28, at 18
(``[Independent] counsel can help to ensure that the directors
understand their responsibilities, ask the pertinent questions, and
receive the information necessary to carry out those
responsibilities.''); What's the Job of Your Fund Counsel?, Fund
Directions, Nov. 1995, at 4, 5 (Independent directors ``look to
their lawyer for assistance in resolving and acting upon any matters
where the adviser potentially has a conflict of interest with the
shareholders.' '') (quoting Edward T. O'Dell, partner, Goodwin,
Procter & Hoar LLP).
\75\ Joel H. Goldberg, Disinterested Directors, Independent
Directors and the Investment Company Act of 1940, 9 Loy. U. Chi.
L.J. 565, 585 (1978).
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We believe counsel who does not also represent the fund's adviser
can best provide zealous representation of independent directors.
Several of our Roundtable participants made this point,\76\ as have
many legal commentators over the years.\77\ The recent ICI Advisory
Group Report recommended that independent directors have qualified
counsel who is independent from the fund's adviser and other service
providers.\78\ Courts too have recognized that independent legal
counsel improves the deliberative process of fund independent
directors.\79\ As a result, independent directors of many funds retain
legal counsel who does not also represent the adviser and, in some
cases, does not represent the fund.
---------------------------------------------------------------------------
\76\ See Roundtable Transcript of Feb. 24, 1999 at 178
(statement of John C. Coffee, Jr.) (``[T]he central lesson from
corporate governance generally is that independent directors can
function well as a committee if an probably only if they have the
effective assistance of a truly independent legal counsel who does
not generally represent the investment adviser and who does not have
any other conflict.''); id. at 190-97 (statement of Leslie L. Ogg)
(discussing the important role of service providers, including
separate counsel, to fund independent directors); id. at 52
(statement of David M. Butowsky) (stating that independent directors
should be counseled by someone ``who is completely independent of
any affiliation with management when reviewing found reorganizations
following the acquisition of an adviser); id. at 67 (statement of
Joseph Hankin) (noting that retaining counsel separate from fund
management is ``absolutely a prudent step'' when reviewing fund
mergers and advisory contracts); see also id. at 222-23 (statement
of David A. Sturms) (reviewing various structures of legal
representation of a fund, its independent directors, and its
adviser).
\77\ See, e.g., Martin Lipton, Directors of Mutual Funds:
Special Problems, 31 BUS. LAW. 1259, 1262 (1976) (``[M]utual funds
should have separate counsel. Either the independent directors of a
fund should have separate counsel or the fund itself should have
separate counsel. That is, separate counsel from counsel for the
management company. Independent counsel plays a very important
role.''); Goldberg, supra note 75, at 585 (``[T]he value of
[independent] counsel in helping to ensure independent consideration
of issues by disinterested directors is beyond dispute * * *.'');
Jean W. Gleason, Mutual Fund Governance: Independent Directors--
Their Role and Incentives and Tools for Fulfilling It, VI-A-9, VI-A-
16 (1994) (material prepared for the 1994 Mutual Funds and
Investment Management Conference) (``Access to, and use of, outside
experts [such as independent legal counsel] can provide increased
independence and allow for informed judgments [by independent
directors] * * *.''). See also Public Policy Report, supra note 10,
at 130-31 (listing the absence of separate legal counsel as one of
the factors contributing to the relative ineffectiveness of
unaffiliated directors).
\78\ See ICI Advisory Group Report, supra note 28, at 18-20. The
Advisory Group concluded that ``[c]ounsel to the independent
directors must be independent from the adviser and other fund
service providers in order to render objective advice on areas of
potential conflict between the fund and its service providers.'' Id.
at 18. See also Fund Director's Guidebook, supra note 62, at 23
(``[G]enerally it is important that the independent directors have
ready access to counsel who views the board and the fund, not the
adviser, as the client.'').
\79\ See Tannenbaum v. Zeller, 552 F.2d 402, 428 (2d Cir. 1977)
(stating that it would have been preferable if the fund's
independent directors received advise from an independent counsel,
rather than counsel who also represented the fund, the fund's
adviser, and the fund's distributor); Fogel v. Chestnutt, 533 F.2d
731, 750 (2d Cir. 1975) (``It would have been * * * better to have
the investigation of recapture methods and their legal consequences
performed by disinterested counsel furnished to the independent
directors.''); Schuyt v. Rowe Price Prime Reserve Fund, Inc., 663 F.
Supp. 962, 965, 982, 986 (S.D.N.Y.) (noting that ``[d]uring all
relevant times, the independent directors * * * had their own
counsel'' who was an ``important resource'' and who advice ``the
record indicates the directors made every effort to keep in mind as
they deliberated''), aff'd, 835 F.2d 45 (2d Cir. 1987); Cartenberg
v. Merill Lynch Asset Management, Inc., 528 F. Supp. 1038, 1064
(S.D.N.Y. 1981) (noting that the ``non-interested Trustees were
represented by their own independent counsel * * * who acted to give
them conscientious and competent advice''), aff'd, 694 F.2d 923 (2d
Cir. 1982). See also Palilsky v. Berndt, [1976-1977 Transfer Binder]
Fed. Sec. L. Rep. (CCH) para. 95,627, 15 90,133 (S.D.N.Y. June 24,
1976) (noting that a law firm, in advising both a fund and the
fund's adviser, ``was counseling people with contrary interests. * *
* The effect of the inadequate advice was to discourage any
independent inquiry by * * * [the] Board.'').
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We are aware, however, that in some cases counsel has regularly
represented the fund, the fund's adviser, and the independent
directors. We have no doubt that such representation has been in
conformity with applicable codes of legal ethics, which permit a lawyer
to represent clients with conflicting interests after full disclosure
and client consent.\80\ We nevertheless are troubled by such conflicts
and how they affect the ability of independent directors to carry out
their responsibilities under the Act and the Exemptive Rules. We are
particularly concerned when lawyers represent both the independent
directors and management organizations in the negotiation of the
advisory contract, distribution arrangements (e.g., 12b-1 plans), and
other matters of fundamental importance to a fund and its shareholders.
Lawyers representing
[[Page 59834]]
fund management may not suggest courses of action to independent
directors that are opposed by their management clients. Thus, we are
proposing to amend the Exemptive Rules to require that counsel for a
fund's independent directors not also act as counsel to the fund's
adviser, principal underwriter, or administrator (or their control
persons).\81\
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\80\ See American Bar Association, Center for Professional
Responsibility, Model Rules of Professional Conduct [``ABA Model
Rules''], Rule 1.7 (1998); see also Del. Prof. Cond. R. 1.7 (1998);
MASS. SUP. JUD. CT.R. 3:07, R.P.C. 1.7 (1999); Md. Rule 1.7 (1998).
\81\ Our proposals are not intended to regulate the practice of
law, but rather to delimit the ability of independent fund directors
to waive certain conflicts of interest. In other contexts,
fiduciaries have been similarly restricted in their ability to waive
conflicts. See, e.g., section 327 of the U.S. Bankruptcy Code [11
U.S.C. 327] (bankruptcy trustee generally cannot employ a counsel
who represents an interest adverse to the estate in bankruptcy, and
any counsel employed by the trustee must be a disinterested person);
Md. Regs. Code tit. 13 Sec. 105 (attorney to a receiver or assignee
in bankruptcy must meet prescribed independence standards, including
that the attorney does not represent an interest adverse to the
estate). See also rule 116.5 of the Bureau of Indian Affairs [25 CFR
116.5] (no person with a personal, financial, or business connection
to a trustee of restricted Indian property may act as an appraiser
of that property in connection with loans made from the trust).
---------------------------------------------------------------------------
We are not, however, proposing at this time to require independent
directors to retain legal counsel. Although we believe that independent
directors are in the best position to fulfill the roles assigned to
them by the Exemptive Rules if they have the assistance of independent
counsel, the services of counsel do not come without cost.\82\ We are
hesitant to propose a rule that might result in the engagement of legal
counsel simply to fulfill a legal requirement. Moreover, we believe
that a likely result of our proposed amendments would be that fund
directors will seek independent counsel. Comment is requested whether
we should amend the Exemptive Rules to require independent directors of
funds relying on those rules to retain independent legal counsel. Would
this requirement impose substantial costs on small fund groups? If we
adopt this condition to the Exemptive Rules, should we provide for an
exception for smaller fund groups? If so, what factors should determine
which fund groups are small?
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\82\ In the 1992 Protecting Investors Report, the staff of the
Division of Investment Management considered, but did not recommend,
requiring funds to provide independent directors with their own
counsel. While the staff recognized the benefits of separate counsel
for independent directors, it was concerned about the costs
associated with requiring separate counsel in all cases. See 1992
Protecting Investors Report, supra note 9, at 268.
---------------------------------------------------------------------------
Under the proposed amendments, reliance on each of the Exemptive
Rules would be conditioned on any legal counsel for a fund's
independent directors being an ``independent legal counsel.'' \83\ A
person would be an ``independent legal counsel'' if the fund reasonably
believes the person and his law firm, partners, and associates \84\
have not acted as legal counsel for the fund's investment adviser,
principal underwriter, administrator \85\ (collectively, ``management
organizations''), or any of their control persons \86\ at any time
since the beginning of the fund's last two completed fiscal years.\87\
The independent directors could make an exception and permit a person
to serve as independent legal counsel even if the person has a remote
or minor conflict of interest because the person has provided legal
advice to management organizations or their control persons.\88\
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\83\ See proposed rules 10f-3(b)(11)(ii); 12b-1(c)(2); 15a-
4(c)(2); 17a-7(f)(2); 17a-8(c)(2); 17d-1(d)(7)(v)(B); 17e-1(c)(2);
17g-1(j)(3)(ii); 18f-3(e)(2); 23c-3(b)(8)(ii).
\84\ The proposed definition of an independent legal counsel
would apply to a ``person.'' See proposed rule 0-1(a)(6)(i). The
term ``person'' would have the same meaning as in section 2(a)(28)
of the Act [15 U.S.C. 80a-2(a)(28)] and, in addition, would include
a partner, co-member, or employee of any person. See proposed rule
0-1(a)(6)(ii)(A). The term ``co-member'' is intended to address law
firms organized as limited liability companies. The interest-holders
of limited liability companies generally are called ``members.''
\85\ See infra note 89.
\86\ See infra note 91 and accompanying text.
\87\ See proposed rule 0-1(a)(6)(i)(A). We intend that the
phrase ``act as legal counsel'' as used in the proposed definition
of ``independent legal counsel'' will have the same meaning that it
has for purposes of section 2(a)(19)(B)(iv) [15 U.S.C. 80a-
2(a)(19)(B)(iv)]. The staff has interpreted the phrase ``acts as
legal counsel'' broadly. See 399 Fund, SEC No-Action Letter (Sept.
2, 1973) (fund directors would be an ``interested person'' because
his firm had entered an appearance on behalf of certain officers and
directors of the fund's adviser in litigation unrelated to the
fund); Alpha Investors Fund, Inc., SEC No-Action Letter (Jan. 9,
1972) (fund director would be an ``interested person'' because his
firm had performed two small legal projects for a company that owned
a 50 percent share of an adviser to a fund).
In some cases, ethics rules permit counsel to accept payment for
legal services from a non-client third party. See ABA Model Rules,
supra note 79, rule 1.8(f) (1998) (counsel may accept compensation
from a third party if (i) the client consents after consultation,
(ii) there is no interference with counsel's independence of
professional judgment or with the attorney-client relationship, and
(iii) counsel maintains client confidentiality); see also id. Rule
1.7 cmt. 10 (``Interest of Person Paying for a Lawyer's Service'').
Under our proposed amendments, we would not view a lawyer as
``acting as legal counsel'' to a fund's investment adviser merely
because the lawyer accepts payment of fees from the adviser for
legal services performed on behalf of the fund or its independent
directors as permitted by relevant professional ethics rules.
\88\ See infra Section 11.A.3(d) ``Exception''; proposed rule 0-
1(a)(6)(i)(B).
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(a) Independent of Fund Management Organizations. The proposed
amendments would treat as fund management organizations, fund advisers
(including sub-advisers), principal underwriters, and fund
administrators.\89\ We are proposing to include fund administrators
because, in some fund complexes, an administrator performs many of the
management functions traditionally performed by a fund's adviser, and
thus may have the same types of conflicts as an investment adviser
sponsoring a fund.\90\ The limitations on dual representation also
would extend to control persons of fund management organizations:
persons who directly or indirectly control, are controlled by, or are
under common control with the adviser, principal underwriter, or fund
administrator.\91\ Counsel to both a parent company of the fund's
adviser and a fund's independent directors, for example, may face the
same conflicts as those faced by counsel to the fund's adviser and the
fund's independent directors.\92\ We request comment whether the
amendments should extend to other types of service providers in
addition to management organizations,\93\ and to persons other than
control persons (e.g., affiliated persons of a management
organization).
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\89\ We are proposing to define ``administrator'' as any person
who provides significant administrative or business affairs
management services to a fund. Proposed rule 0-1(a)(5). This
definition is substantially similar to, and has the same meaning as,
the definition of administrator contained in Item 22(a)(1)(i) of
Schedule 14A and Item 15(h)(1) of Form N-1A.
\90\ Funds are increasingly turning to third-party fund
administrators to provide an array of services, including
shareholder servicing, recordkeeping, accounting, and fund
distribution. See Jackie Cohen, Priming the Pump for Better Mutual
Fund Sales, Bank Tech. News, June 1998, at 43; Katharine Fraser,
Fund Administrators Vie for Megabank Pacts, Am. Banker, May 27,
1998, at 10. As of December 31, 1998, third-party fund
administrators had approximately $527 billion in assets under
administration. See generally Lipper Inc., Lipper Directors'
Analytical Data: Executive Summary (1st ed. 1999) (providing
estimates of fund assets administered by entities other than funds,
from which estimates of fund assets administered by entities
unaffiliated with the fund may be derived).
\91\ The definition of ``control person'' would exclude funds.
This exclusion enables the same counsel to represent a fund and its
independent directors. See proposed rule 0-1(a)(6)(ii)(B); see also
infra note 94 and accompanying text.
\92\ This could be the case even if the legal work performed for
the control person is unrelated to the fund or its operations.
\93\ See ICI Advisory Group Report, supra note 28, at 19
(recommending counsel for the independent directors who is
independent from all of the fund's service providers).
---------------------------------------------------------------------------
Under the proposed amendments, a person could be an independent
legal counsel to a fund's independent directors regardless of the
nature and amount of legal services he or she provides to the fund
itself. A person acting as both fund counsel and independent director
counsel ordinarily should not have the types of conflicts of interest
that would diminish the counsel's ability to provide zealous
[[Page 59835]]
representation of independent directors.\94\ Similarly, our proposal
would not preclude counsel from representing the independent directors
of multiple funds affiliated with the same management organization. We
request comment on this provision.
---------------------------------------------------------------------------
\94\ See id. at 18-19 (`'The Adisory Group believes that counsel
for the independent directors also may serve as fund counsel
because, in virtually every situation except possibly litigation,
the interests of the fund and its directors are aligned.''). But see
Roundtable Transcript of Feb. 24, 1999 at 179 (statement of John C.
Coffee, Jr.) (noting that counsel to a fund invariably works closely
with, and generally receives work requests from, personnel of the
adviser who manages the fund, and that the close association with
the adviser that results from representing the fund could influence
the counsel's representation of the independent directors).
---------------------------------------------------------------------------
(b) Two-Year Period. Section 2(a)(19) of the Act prevents any
person who has acted as legal counsel to a fund's adviser or principal
underwriter during the last two years from serving as an independent
director of the fund.\95\ This section reflects Congress's belief that
acting as counsel to fund management organizations creates conflicts
that may affect a person's ability to represent shareholder interests.
Based upon similar considerations, the proposed amendments would
(subject to the exception discussed below) preclude a person from
acting as counsel for independent directors for two years after having
acted as legal counsel to a fund management organization or its control
person. As in section 2(a)(19), the disqualification would apply to any
partner or employee of a person who acted as legal counsel to the
management organization or its control person.\96\
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\95\ Section 2(a)(19)(B)(vi). Section 2(a)(19)(A)(iv) of the Act
[15 U.S.C. 80a-2(a)(19)(A)(iv)] also precludes a person who has
acted as fund counsel from serving as an independent director of
that fund for at least two years. As discussed above, our proposal
would not preclude counsel to a fund from serving as counsel to a
fund's independent directors. See supra note 94 and accompanying
text.
\96\ See proposed rule 0-1(a)(6)(ii)(A); see also supra note 84.
---------------------------------------------------------------------------
(c) Reasonable Belief. The proposed amendments would require the
fund to have a ``reasonable belief'' that counsel to the independent
directors meets the requirements of the independent legal counsel
definition. If, despite the fund's reasonable belief, counsel does not
actually meet the requirements, the fund would not lose the ability to
rely on any of the Exemptive Rules. A fund could form a reasonable
belief based on a representation from counsel. If the fund relies on
counsel's representation, the fund also should obtain an undertaking
that the counsel will inform the fund and the independent directors if
it begins to act as legal counsel to the fund management organizations
or any of their control persons.
(d) Exception. As discussed above, these proposed amendments are
intended to assure that independent directors have the benefit of
counsel who is free from the types of conflicts that may affect the
advice provided to independent directors. The scope of the proposed
limitation, described above, is broad and covers direct and indirect
conflicts. As a result, the proposed amendments might preclude a person
from serving as counsel to a fund's independent directors because of a
remote or minor conflict involving, for example, a law-firm partner who
represented an affiliate of the fund's adviser in a minor real estate
transaction. Therefore, the proposed definition of ``independent legal
counsel'' includes an exception that would permit the independent
directors to retain the counsel if they determine that the counsel's
representation was ``so limited that it would not adversely affect the
counsel's ability to provide impartial, objective, and unbiased legal
counsel to the [independent] directors.'' \97\
---------------------------------------------------------------------------
\97\ See proposed rule 0-1(a)(6)(i)(B).
---------------------------------------------------------------------------
The exception would not permit waivers in all instances, but only
in circumstances where the nature or extent of the conflict is minor.
We would expect that the independent directors, in making a
determination under the exception, would consider all relevant factors.
These factors could include whether the representation presented a
direct and ongoing conflict with the fund, the amount of legal fees
generated by the representation, and the nature and the extent of the
affiliation between a control person and a fund management
organization. The basis for any determination under this provision also
must be recorded in board meeting minutes.\98\
---------------------------------------------------------------------------
\98\ See id.
---------------------------------------------------------------------------
We request comment on the approach we have taken. Should
independent directors who engage legal counsel under the exception to
the general rule be required to make findings different from those
proposed? For example, the Blue Ribbon Committee on Improving the
Effectiveness of Corporate Audit Committees recommended that a director
who does not meet proposed independence standards be allowed to serve
as a member of a company's audit committee if the board, under
exceptional and limited circumstances, determines that membership on
the committee is required by the best interests of the company and its
shareholders, and the board discloses, in the next annual proxy
statement, the reasons why the director does not meet the independence
standards and the reasons for the board's determination.\99\ Should we
also require public disclosure of the independent directors'
determination regarding their counsel's conflict and the nature of that
conflict? If so, in what document should the disclosure be made?
---------------------------------------------------------------------------
\99\ See Report and Recommendations of the Blue Ribbon Committee
on Improving the Effectiveness of Corporate Audit Committees 11
(1999) [``Blue Ribbon Committee Report''].
---------------------------------------------------------------------------
(e) Transition Period. If we adopt the proposals after the comment
period, counsel for the independent directors of funds relying on any
of the Exemptive Rules would not be required to be ``independent legal
counsel'' until the compliance date established in the adopting
release. We believe that independent directors of most fund groups
would not be required to seek new counsel. In some cases, however, they
may. Comment is requested on the transition time that independent
directors would need to hire new counsel.
B. Limits on Coverage of Directors Under Joint Insurance Policies
The oversight responsibilities that the Act assigns to independent
directors \100\ may create tensions between those directors and the
fund's adviser \101\ that can lead to disputes.\102\ A dispute among
these parties that escalates to the level of a lawsuit can result in
significant legal expenses for the independent directors.\103\
---------------------------------------------------------------------------
\100\ See supra notes 12-24 and accompanying text; see also
section 36(a) of the Act [15 U.S.C. 80a-35(a)] (enabling federal
lawsuits to be brought against fund directors for breaches of
fiduciary duty involving personal misconduct).
\101\ See Roundtable Transcript of Feb. 24, 1999 at 234
(statement of Gerald C. McDonough) (``The adversarial role * * * of
independent [directors] and fund advisers is a healthy and desirable
one.'').
\102\ See David A. Sturms, The Debate: The System is Broken--Fix
It or Scrap It vs. The System Works--Don't Fix What Isn't Broken 4-7
(materials prepared for SEC Roundtable on the Role of Independent
Investment Company Directors, Feb. 23-24, 1999) (discussing recent
disputes between independent directors of funds and the funds'
advisers).
\103\ See ICI Advisory Group Report, supra note 28, at 26
(``[L]itigation [involving independent directors] can be extremely
expensive and may even carry with it a potential for personal
financial ruin.'').
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Funds typically purchase ``errors and omissions'' insurance
policies (``D&O/E&O policies'') \104\ to cover expenses
[[Page 59836]]
incurred by directors and officers in the event of litigation.\105\
Often these policies are joint policies that cover numerous funds
within a fund family as well as the adviser and principal underwriter
of those funds. Although the Investment Company Act and our rules
generally prohibit joint transactions and other joint arrangements
involving a fund and its affiliates,\106\ rule 17d-1(d)(7) permits the
purchase of joint D&O/E&O policies.\107\
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\104\ D&O/E&O policies generally insure directors and officers
of an insured entity (e.g., a fund) for claims made against them for
their designated acts, errors, or omissions. See generally Spiro K.
Bantis, ``What Mutual Fund D&O/E&O Policies Don't Cover''; Ellen
Metzger, Mutual Fund D&O/E&O Insurance: Considerations in Selecting
and Maintaining a Policy; Natalie Shirley, Claims--What to Do When
the Unthinkable Happens; Daniel T. Steiner, Selected Issues
Regarding Basic Policy Forms (collected materials from 1995 Mutual
Funds and Investment Management Conference, Mutual Fund D&O/E&O
Insurance 101).
\105\ Under the Act, a fund's organizational documents cannot
contain any provision protecting a director or officer of the fund
from any liability to the fund or its shareholders to which he is
subject by reason of willful misfeasance, bad faith, gross
negligence, or reckless disregard of the duties involved in the
conduct of his office. See section 17(h) of the Act [15 U.S.C. 80a-
17(h)]; see also Interpretive Release, supra note 1, Section II.C
(discussing section 17(h) and providing guidance regarding when a
fund may pay an advance of legal fees to its directors).
\106\ See section 17(d) [15 U.S.C. 80a-17(d)] (prohibiting an
affiliated person of a fund from effecting a joint transaction with
the fund in contravention of Commission rules); rule 17d-1 [17 CFR
270.17d-1] (prohibiting a fund affiliate from participating in any
joint enterprise, joint arrangement, or profit-sharing plan with a
fund without first obtaining a Commission order, except in certain
designated circumstances); see also Interpretive Release, supra note
1, Section II.B (discussing section 17(d) and rule 17d-1 and
explaining the view of the staff that actions taken by fund
directors within the scope of their duties for the fund generally
would not be joint transactions under section 17(d) and rule 17d-1).
\107\ 17 CFR 270.17d-1(d)(7). Reliance on rule 17d-1(d)(7)
currently is conditioned on a fund's board, and a majority of its
independent directors, annually determining that the joint policy is
in the best interests of the fund and that the proportion of the
policy's premium allocated to the fund is fair and reasonable.
---------------------------------------------------------------------------
Joint D&O/E&O policies historically have excluded claims in which
the parties under the policy sue each other.\108\ A policy that insures
both a fund's investment adviser and its independent directors
therefore may not cover the independent directors' expenses of
litigation with the fund's adviser. Without this coverage, independent
directors face substantial personal legal expenses in the event of a
lawsuit.\109\
---------------------------------------------------------------------------
\108\ See ICA Advisory Group Report, supra 28, at 26. The
general purpose of these standard ``insured versus insured''
exclusions is to prevent collusion among insureds.
\109\ See Paul H. Dykstra and Paulita Pike-Bokhari, The Yacktman
Battle: Manager Bites the Watchdogs, Investment Law., Nov./Dec.
1998, at 1, 9-10 (discussing the effect of an ``insured versus
insured'' exclusion of insurance coverage on independent directors
of the Yacktman Fund).
---------------------------------------------------------------------------
The exclusion of coverage under joint policies creates a potential
threat to directors' personal assets, which can hamper directors'
willingness to question management and weaken their resolve to protect
fund shareholders in the event of a conflict with the adviser. Because
we are concerned about the effect that these exclusions may have on the
ability of independent directors to carry out their statutory
responsibilities, we propose to amend rule 17d-1(d)(7) to make the rule
available only for joint liability insurance policies that do not
exclude coverage for litigation between the independent directors and
the fund's adviser.\110\ These proposals are intended to allow
independent directors to engage in the good faith performance of their
statutory responsibilities without concern for their personal financial
security.\111\
---------------------------------------------------------------------------
\110\ Proposed rule 17d-1(d)(7)(iii). The proposed amendments
would prohibit exclusions for bonafide (i.e., non-collusive) claims
made against any independent director by another person insured
under the joint insurance policy. The proposed amendments also would
prohibit exclusion of coverage for the fund if it is a co-defendant
with an independent director in a claim brought by a co-insured. We
believe that the ability of fund directors to perform their duties
may be further impaired if an adviser's lawsuit poses a threat to
fund assets as well as to director's personal assets.
\111\ Earlier this year, Chairman Levitt expressed concern about
standard ``insured versus insured'' exclusions. See Arthur Levitt,
Keeping Faith with the Shareholder Interest: Strengthening the role
of Independent Directors of Mutual Funds (remarks at the Mutual
Funds and Investment Management Conference, Palm Springs, CA, Mar.
22, 1999), available at http://www.sec.gov/news/speeches/
spch259.htm>. In response, the ICI Mutual Insurance Company (``ICI
Mutual''), which insures funds representing approximately 70 percent
of all mutual fund assets, recently announced that it has revised
its D&O/E&O policies to clarify that these types of claims are
covered under its standard insurance policy. See Aaron Lucchetti,
Direct and Protect, Wall St. J., April 2, 1999, at C23. ICI Mutual
now makes available a standard policy endorsement that permits
independent directors to recover defense costs, settlements, and
judgments in ``insured versus insured'' claims otherwise covered
under the policy. This change by ICI Mutual is a significant step
toward ensuring the ability of independent directors to vigorously
fulfill their duties under the Act without concerns of personal
liability. We believe, however, that all independent directors who
serve on funds that obtain joint liability insurance policies should
have the benefit of protections similar to those provided by ICI
Mutual.
---------------------------------------------------------------------------
We request comment on the proposed amendments to rule 17d-1(d)(7)
concerning the purchase of joint D&O/E&O policies. The ICI Advisory
Group Report recommended more broadly that fund boards should consider
obtaining D&O/E&O insurance policies and/or indemnification from the
fund ``that is adequate to ensure the independence and effectiveness of
independent directors.'' \112\ The proposed amendments do not require
that funds obtain insurance coverage or indemnification for independent
directors, so that funds will have the latitude to determine which
arrangements are appropriate for their circumstances. We request
comment whether we should further amend rule 17d-1(d)(7) to require
that joint insurance polices purchased under the rule be in an amount
adequate to ensure that independent directors can perform their duties
in an independent and effective manner, and what that amount might be.
---------------------------------------------------------------------------
ICI Advisory Group Report, supra note 28, at 26. the Report also
noted that independent directors may need to be covered by insurance
after their service on the board has ended for claims involving
their service as directors. Id. at 26-27.
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C. Exemption From Ratification of Independent Public Accountant
Requirement for Funds With Independent Audit Committees
The Investment Company Act requires that a fund's independent
directors select the fund's independent public accountant.\113\ The Act
further requires that the selection of the fund's independent public
accountant be submitted to shareholders for ratification or rejection
at their next annual meeting.\114\
---------------------------------------------------------------------------
\113\ Section 32(a)(1).
\114\ Section 32(a)(2) [15 U.S.C. 80a-31(a)(2)].
---------------------------------------------------------------------------
We have observed that shareholders rarely contest votes over the
ratification of the selection of a fund's independent accountant. Many
believe shareholder ratification has become perfunctory. This may have
occurred because of the growth of funds,\115\ their organization into
large complexes, the increased complexity of accounting issues, or the
consolidation of accounting firms, which have made it impracticable for
shareholders to evaluate the qualifications and independence of fund
auditors. We are proposing, therefore, to exempt funds from the
shareholder ratification requirement if the auditor is subject to the
oversight and direction of an audit committee consisting entirely of
independent directors.
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\115\ See supra note 3 and accompanying test.
---------------------------------------------------------------------------
Today, in many corporations and fund complexes, audit committees
play an important and growing role in assuring the integrity of
financial statements.\116\ The current listing
[[Page 59837]]
requirements of the primary U.S. securities exchanges require publicly
traded companies to have audit committees,\117\ and many commentators
have recognized the value of independent audit committees and the
significance of their function in a corporate governance
structure.\118\ Recently, the Blue Ribbon Committee on Improving the
Effectiveness of Corporate Audit Committees emphasized the important
role of audit committees and recommended enhanced responsibilities,
membership standards, and methods of operation designed to strengthen
their oversight function.\119\ The ICI Advisory Group Report,
furthermore, recommended that fund boards establish audit committees
comprised entirely of independent directors.\120\
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\116\ See generally A.B.A., Section of Business Law, Corporate
Director's Guidebook 27-32 (2d ed. 1994) [``1994 Corporate
Director's Guidebook'']; See also Investment Company Institute,
Understanding the Role of Mutual Fund Directors 7 (1998) (noting
that although not required by law, it is common practice for mutual
funds to have an audit committee oversee the financial reporting and
internal controls of the fund and stating that the results of a 1998
survey conducted by Management Practice Inc. indicated that 100
percent of fund boards surveyed had an audit committee); Fund
Director's Guidebook, supra note 62, at 26 (stating that the audit
committees of many funds are comprised of all of the fund's
independent directors).
\117\ See e.g., New York Stock Exchange Listed Company Manual
para. 303.00.
\118\ See, e.g., Roundtable Transcript of Feb. 23, 1999 at 236
(statement of Manuel H. Johnson) (noting that an audit committee
comprised entirely of independent directors serves as a check and
balance); 1994 Corporate Director's Guidebook, supra note 116, 27
(``The Audit Committee should be composed solely of independent
directors.''); Fund Director's Guidebook, supra note 62, at 25-26
(noting that the boards of many public companies, including funds,
have established audit committees at the urging of many governmental
and non-governmental institutions that have determined that audit
committees can play a meaningful role in ensuring corporate
accountability), The Role and Composition of the Board of Directors
of the Large Publicly Owned Corporation: Statement of the Business
Roundtable, 33 Bus. Law. 2083, 2108, 2109 (1978) (``[W]e believe it
highly desirable * * * that the board be served by an Audit
Committee.'' THe audit committee should be ``composed entirely of
non management directors.'') Report of the National Commission on
Fraudulent Financial Reporting 12 (Oct. 1987) [``Treadway Report'']
(``The audit committee on the board of directors plays a role
critical to the integrity of the company's financial reporting. [We]
recommend[] that all public companies be required to have audit
committees composed entirely of independent directors.''); Advisory
Panel on Auditor Independence, Strengthening the Professionalism of
the Independent Auditor 14 (Sep. 13, 1994) (Special Report to the
Oversight Board of the SEC Practice Section, AICPA [``Kirk Panel
Report''] (noting that it is important that companies have audit
committees of independent directors).
\119\ Blue Ribbon Committee Report, supra note 99. With respect
to independence of audit committee members, the Blue Ribbon
Committee Report states:
[I]t is widely recognized that each member of the audit
committee should be an independent director. Several recent studies
have produced a correlation between audit committee independence and
two desirable outcomes: a higher degree of active oversight and a
lower incident of financial statement fraud. In addition, common
sense dictates that a director without any financial, family, or
other material personal ties to management is more likely to be able
to evaluate objectively the propriety of management's accounting
internal control and reporting practices.
Id. at 22.
\120\ ICI Advisory Group Report, supra note 28, at 22-23.
---------------------------------------------------------------------------
We believe that the ongoing oversight provided by an independent
audit committee can provide greater protection to shareholders than the
current requirement for shareholder ratification of a fund's
independent auditors. We therefore are proposing a rule that would
exempt a fund from the Act's requirement that shareholders ratify or
reject the selection of the fund's independent public accountant if the
fund has an audit committee comprised wholly of independent
directors.\121\ In order for a fund to rely on the proposed exemption,
(i) the audit committee must be responsible for overseeing the fund's
accounting and auditing processes,\122\ (ii) the fund's board of
directors must adopt an audit committee charter setting forth the
committee's structure, duties, powers, and methods of operation,\123\
and (iii) the fund must maintain a copy of the charter.\124\
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\121\ See proposed rule 32a-4(b). A closed-end fund listed on a
stock exchange also is subject to the exchange's listing
requirements regarding audit committees. See, e.g., Supra note 117
and accompanying text.
\122\ Proposed rule 32a-4(a).
\123\ Proposed rule 32a-4(c).
\124\ Proposed rule 32a-4(d). Under the current requirements of
rule 31a-1(b)(4) [17 CFR 270.31a-1(b)(4)], funds also would be
required to maintain minute books of the audit committee's meetings.
---------------------------------------------------------------------------
We request comment regarding the conditions of the proposed rule.
Should the exemption require that the charter set forth certain
specific responsibilities and methods of operation? Should funds
relying on the exemption be required to provide a copy of their audit
committee charter as an exhibit to their registration statement, and
should the board be required to review the charter on an annual basis?
Should the exemption require fund audit committees to obtain an annual
representation from the fund's independent public accountant certifying
its independence, as the ICI Advisory Group suggested? \125\ Should the
exemption include other conditions that are similar to the
recommendations of the ICI Advisory Group and Blue Ribbon Committee on
Improving the Effectiveness of Corporate Audit Committees?
---------------------------------------------------------------------------
\125\ See ICI Advisory Group Report, supra note 28, at 22-23.
Cf. Independence Standards Board Standard No. 1: Independence
Discussions with Audit Committees (Jan. 1999) (requiring, for all
funds with fiscal years ending after July 19, 1999, that a fund's
auditor provide an annual representation of the auditor's
independence).
---------------------------------------------------------------------------
The proposed rule assumes that the appropriate form for the
instrument governing an audit committee is a charter. Should the rule
explicitly recognize that the audit committee provisions could be
included in a document other than the charter, such as the fund's by-
laws, articles of incorporation, or declaration of trust?
D. Qualification as an Independent Director
In addition to the amendments to enhance the independence of fund
boards, we are proposing amendments to prevent qualified individuals
from being unnecessarily disqualified from serving as independent
directors. The Investment Company Act sets standards for who may be
considered an independent director.\126\ While these standards are
meant to exclude individuals with affiliations or business interests
that can impair their independence, there are circumstances in which
the standards may cause certain individuals to be unnecessarily
disqualified from serving as an independent director. For this reason,
Congress directed the Commission to apply the standards ``in a flexible
manner'' and adopt appropriate exemptions.\127\ Today we are proposing
(i) to amend the rule that permits directors to be considered
independent directors even if they are affiliated with a broker-dealer,
and (ii) a new rule that would prevent directors from being
disqualified as independent directors solely because they own shares of
index funds that hold limited interests in their fund's adviser or
principal underwriter.
---------------------------------------------------------------------------
\126\ For example, the Act provides that no person can be an
independent director to a fund if he is affiliated with the fund
itself, or with the fund's investment adviser or principal
underwriter. Section 2(a)(19)(A)(i), (A)(iii), (B)(i) [15 U.S.C.
80a-2(a)(19)(A)(i), (A)(iii), (B)(i)]. See generally infra note 170.
\127\ See H.R. Rep. No. 1382, 91st Cong., 2d Sess. 15 (1970).
---------------------------------------------------------------------------
1. Affiliation With a Broker-Dealer
Section 2(a)(19) of the Act provides that no person can be an
independent director if he is, or is affiliated with, a registered
broker-dealer.\128\ This provision is designed to prevent independent
directors from being influenced by a business relationship with broker-
dealers.\129\ Rule 2a19-1 under the Act provides relief from this
provision under certain conditions, but only if no more than a minority
of a
[[Page 59838]]
fund's independent directors are broker-dealers or affiliated with
broker-dealers.\130\ When we proposed this condition in 1984, we
explained that allowing all of the fund's independent directors to be
affiliated with broker-dealers would be inconsistent with Congress's
intent to separate independent directors from the brokerage
industry.\131\
---------------------------------------------------------------------------
\128\ Section 2(a)(19)(A)(v), (B)(v) [15 U.S.C. 80a-
2(a)(19)(A)(v), (b) (v)].
\129\ See The First Australia Fund, Inc., SEC No-Action Letter,
at n.8 and accompanying text (Oct. 8, 1987) (``The broad scope of
section 2(a)(19) with respect to brokers and dealers appears to have
been prompted by the many subtle relationships that exist between
persons who are active in the securities markets.'') (citing Public
Policy Report, supra note 10, at 162-88). Congress also may have
adopted this broad prohibition reaction to the nature of fund
brokerage arrangements when fixed commission rates were prevalent.
See Certain Persons Not Deemed Interested Persons; Definition of
Regular Broker or Dealer, Investment Company Act Release No. 13920
(May 2, 1984) [49 FR 19519 (May 8, 1984)] at n.1 [``Rule 2a19-1
Proposing Release''].
\130\ Rule 2a19-1(a)(3) [17 CFR 270.2a19-1(a)(3]. Rule 2a19-1
also requires that the broker-dealer not execute any portfolio
transactions for, engage in any principal transactions with, or
distribute shares for, the fund's ``complex,'' and that the board
determine that the fund and its shareholders will not be adversely
affected if the broker-dealer does not perform those functions for
the fund. Rule 2a19-1(a)(1), (2) [17 CFR 270.2a19-1(a)(1), (2)]. The
rule defines ``complex'' to the fund on whose board the director
serves, its investment adviser and principal underwriter, and other
funds having the same adviser or principal underwriter. Rule 2a19-
1(b) [17 CFR 270.2a19-1(b).
\131\ See Rule 2a19-1 Proposing, supra note 129, at n.36 and
accompanying text.
---------------------------------------------------------------------------
In recent years, some directors have been unable to qualify as
independent directors due to the condition that no more than a minority
of a fund's independent directors may be affiliated with a broker-
dealer. This condition has been especially troublesome for funds with
small boards of directors. For example, if a three-member board has
only two independent directors, neither director can rely on rule 2a19-
1 because it would result in more than a minority of the independent
directors relying on the rule. In these types of circumstances, the
Commission has granted exemptions from this condition of the rule.\132\
---------------------------------------------------------------------------
\132\ See Bergstrom, Capital Corporation, Investment Company Act
Release Nos. 23629 (Dec. 31, 1998) [64 FR 1035 (Jan. 7, 1999)]
(notice) and 23666 (Jan. 26, 1999) [68 SEC Docket 3501 (Feb. 23
1999)] (order); Counsellors Tandem Securities Fund, Inc. and
Warburg, Pincus Counsellors, Inc., Investment Company Act Release
Nos. 15636 (Mar. 24, 1987) [52 FR 10278 (Mar. 31, 1987)] (notice)
and 15697 and 15697 (Apr. 22, 1987) [38 SEC Docket 318 (May 5,
1987)] (order).
---------------------------------------------------------------------------
We are proposing to amend rule 2a19-1 to provide that no more than
one-half of a fund's independent directors may be broker-dealers or
their affiliates.\133\ This condition should make the rule more
flexible for funds with small boards of directors, while continuing to
ensure that not all of a fund's independent directors are broker-
dealers or their affiliates.\134\ We seek comment on whether rule 2a19-
1 should be expanded further.
---------------------------------------------------------------------------
\133\ Proposed amendment to rule 2a19-1(a)(3).
\134\ We also are proposing to amend the title of rule 2a19-1 to
refer specifically to broker-dealers, the subject of the rule.
---------------------------------------------------------------------------
2. Ownership of Index Fund Securities
Section 2(a)(19) disqualifies an individual from being considered
an independent director if he 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.\135\ A fund director, for example, who owns
securities issued by the fund's adviser (or its parent company) could
not be an independent director. This provision was designed to ensure
that an independent director does not have a financial interest in the
organizations that are closely associated with the fund or that would
benefit from payments that the independent director is charged with
scrutinizing.\136\
---------------------------------------------------------------------------
\135\ Section 2(a)(19)(B)(iii) [15 U.S.C. 80a-2(a)(19)(B)(iii)].
\136\ See H.R. Rep. No. 1382, 91st Cong., 2d Sess. 13-14 (1970)
(expressing policy concerns about the use of ``affiliated person''
in the Act because, among other things, it permitted a director to
be classified as ``unaffiliated'' even though he had substantial
business relationships with the fund, its adviser, or its
underwriter); Public Policy Report, supra note 10, at 332-34 (same);
see also section 15(c) of the Act (requiring independent directors
to scrutinize and approve the fund's contracts with investment
advisers and principal underwriters).
---------------------------------------------------------------------------
If a director owns securities of an index fund \137\ that seeks to
replicate 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).\138\ We believe that this attenuated interest in the adviser's
or underwriter's securities is not the type of interest Congress
intended to prohibit independent directors from owning when it adopted
section 2(a)(19). An index fund's investment decision-making process is
dictated by the goal of mirroring the performance of a market index,
and thus is largely mechanical.\139\ Because index fund portfolios
typically are spread among a large number of issuers, ownership of
their shares is unlikely to have a material effect on the independent
judgment of a fund director.
---------------------------------------------------------------------------
\137\ An index fund is a type of fund that selects the
securities in its portfolio in an effort to replicate the investment
performance of the securities in a market index. Nearly 20 percent
of the index funds registered with the Commission track the
performance of the Standard & Poor's 500 Composite Stock Price
Index. For a discussion of other types of indexes, see
John Waggoner, Index Funds Race Into New Venues; Investors Can Track
Europe or Racing Firms, USA Today, Nov. 27, 1998, at 3B.
\138\ Cf. The Massachusetts Company, SEC No-Action Letter (Jan.
29, 1972) (fund director who serves as a trustee of an irrevocable
trust that holds shares of a controlling person of the fund's
adviser and underwriter would be an interested person of the fund
under section 2(a)(19)(B)(iii)).
\139\ Cf., e.g., The Victory Stock Index Fund, SEC No-Action
Letter (Feb. 7, 1995) (staff would not recommend enforcement action
under section 12(d)(3) or rule 12d3-1 when an index fund purchased
securities of an affiliated person of the fund's adviser or
principal underwriter, because, among other things, the ``non-
volitional nature of the index fund's purchases'' made it unlikely
that the fund's portfolio securities would be selected in the
interest of the fund's adviser or principal underwriter, rather than
the fund's shareholders).
---------------------------------------------------------------------------
In order to resolve concerns that may have arisen about the status
of independent directors who own index funds, we are proposing a new
rule that would conditionally exempt an individual from being
disqualified as an independent director merely because he owns shares
of an index fund that invests in the adviser or underwriter of the
fund, or their controlling persons.\140\ The exemption would be
available if the value of securities issued by the adviser or
underwriter (or controlling person) does not exceed five percent of the
value of any index tracked by the index fund.\141\ The purpose of this
condition is to assure that an independent director's indirect interest
in the adviser's securities will not be substantial enough to impair
his independence and create a conflict of interest.
---------------------------------------------------------------------------
\140\ The proposed rule would not address an independent
director's ownership of securities of an actively managed fund. The
holdings of this type of fund can vary from day to day without the
knowledge of the fund's shareholders, and periodic disclosure of
fund holdings may be out of date by the time an investor receives
them. We therefore believe it is clear that an independent director
who owns shares of an actively managed fund ordinarily would not
``knowingly'' have an indirect beneficial interest in the issuers of
securities the fund holds.
\141\ Proposed rule 2a19-3.
---------------------------------------------------------------------------
The proposed rule would define an ``index fund'' as a fund with an
investment objective to replicate the performance of a securities index
or indices.\142\ We request comment on the proposed definition of index
fund. Does it encompass the types of funds for which relief is
appropriate? Should other types of investment vehicles be included in
the proposed rule? We also request comment on the proposed limit on the
percentage of the value of securities of the adviser or principal
underwriter (or their controlling persons) represented in any index
tracked by the fund. Should the rule allow an independent director to
own index fund shares when the value of the securities issued by the
adviser or underwriter (or their controlling persons) in the index
constitutes more than five percent of the value of any index tracked by
the fund? Should the limit be less than five percent?
---------------------------------------------------------------------------
\142\ Id.
---------------------------------------------------------------------------
[[Page 59839]]
E. Disclosure of Information About Fund Directors
Participants at the Roundtable agreed that independent directors
can vigilantly represent the interests of mutual fund shareholders only
when they are truly independent of those who operate and manage the
fund.\143\ We agree with the Roundtable participants and believe that
the effectiveness of fund boards of directors is enhanced by a high
degree of independence of each independent director.
---------------------------------------------------------------------------
\143\ See, e.g., statement of Bruce K. MacLaury, Roundtable
Transcript of Feb. 23, 1999, at 42 (``It should be apparent that
boards work best when the possibilities for conflict of interest are
minimized so that truly independent directors can exercise their
best judgment on behalf of the interest of the shareholders.'');
statement of Dawn-Marie Driscoll, Roundtable Transcript of Feb. 24,
1999, at 63 (``[I]ndependence is one of the most important
characteristics of an independent director. The more ways that you
can ensure independence the better the process will be.'');
statement of Thomas R. Smith, Jr., Roundtable Transcript of Feb. 24,
1999, at 253 (``There is something beyond what is in the statute
that you consider when you pick new directors. You've got to look at
material business relationships, and, quite frequently, in the
selection process you will rule somebody out, although technically
they are independent, because of relationships.'').
---------------------------------------------------------------------------
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.
The Commission has long recognized the importance of providing
mutual fund shareholders with relevant information about fund directors
and has required funds to provide shareholders with certain information
about fund directors. Currently, information about directors is
available in fund registration statements and proxy statements for the
election of directors. Generally, funds are required to provide basic
information about directors in the statement of additional information
(``SAI'') and proxy statements, including name and age; positions with
the fund; principal occupations during the past five years; and
compensation from the fund and fund complex.\144\ Moreover, funds are
required to disclose in proxy statements for the election of directors
a director's positions with, interests in, and transactions with, the
fund and certain persons related to the fund.\145\
---------------------------------------------------------------------------
\144\ Items 13(b) and (d) of Form N-1A; Items 18.1 and 18.4 of
Form N-2; Items 20(a) and (c) of Form N-3; Items 401(a) and (e) of
Regulation S-K, through Item 22(b)(4) of Schedule 14A.
Funds also are required to disclose for each director the
positions held with affiliated persons or principal underwriters of
the fund. Item 13(c) of Form N-1A; Item 18.2 of Form N-2; Item 20(b)
of Form N-3. Funds also must provide the percentage of the fund's
equity securities owned as a group by all officers, directors, and
advisory board members. Item 14(c) of Form N-1A and Item 19.3 of
Form N-2. See also Items 23(f) and 25 of Form N-1A; Items 24.2.i and
29 of Form N-2; Items 21(a)(ii) and (f)(ii), 28(b)(10), and 32 of
Form N-3.
\145\ See Item 22(b)(1) of Schedule 14A (requiring disclosure of
director's positions with the investment adviser and a director's
securities holdings or material interest in the investment adviser
and any person controlling, controlled by, or under common control
with the investment adviser); Item 401 of Regulation S-K, through
Item 22(b)(4) of Schedule 14A (requiring disclosure of director's
positions with the fund); Item 22(b)(2) of Schedule 14A (requiring
disclosure of any material interests of a director in the fund's
principal underwriter or administrator); Item 22(b)(3) of Schedule
14A (requiring disclosure of any material interests of a director in
any material transactions with the fund, the investment adviser, the
principal underwriter, or the administrator, and any person
controlling, controlled by, or under common control with the
investment adviser, principal underwriter, or administrator); Item
404(a) of Regulation S-K, through Item 22(b)(4) of Schedule 14A
(requiring disclosure of a director's material interests in
transactions with the fund involving amounts over $60,000). Funds
also must disclose in proxy statements a director's holdings in the
fund. Item 403(b) of Regulation S-K, through Item 6(d) of Schedule
14A. See also Items 5, 7(e), (f), and (g), and 22(b)(5) and (b)(6)
of Schedule 14A (requiring other information about directors).
---------------------------------------------------------------------------
For some time, however, we have been concerned that mutual fund
investors do not in all cases have access to significant information
about fund directors when they need it. When we adopted our recent
comprehensive revisions to the mutual fund prospectus, we noted that
mandating more information about fund directors than is available under
our existing rules may be appropriate in light of independent
directors' role as ``watchdogs'' for fund shareholders.\146\ Critics
have charged that shareholders do not know the very people who are
entrusted with safeguarding their interests.\147\ Some have complained
that fund shareholders do not know whether the interests of independent
directors are aligned with shareholders or with fund management.\148\
---------------------------------------------------------------------------
\146\ Registration Form Used by Open-End Management Investment
Companies, Investment Company Act Release No. 23064 (Mar. 13, 1998)
[63 FR 13916, 13931 (Mar. 23, 1998)] (``1998 Form N-1A Release'').
\147\ John Markese, president of the American Association of
Individual Investors, discussed his view that there is a
``disconnect'' between shareholders and the independent directors at
our recent Roundtable. Roundtable Transcript of Feb. 23, 1999, at
48-49. See also Paul J. Lim, Despite Plan to Fortify Independent
Directors, Shareholders Must be Their Own Watchdogs, L.A. Times, Mar
. 28, 1999, at C3; Russ Wiles, ``Fund Directors Losing Clout,'' The
Arizona Republic D1 (Mar. 28, 1999).
\148\ See, e.g., Edward Wyatt, Empty Suits In the Board Room;
Under Fire, Mutual Fund Directors Seem Increasingly Hamstrung, N.Y.
Times, June 7, 1998, at C1; Steven D. Kaye, Whose board is it?, U.S.
News & World Rep., Feb. 2, 1998, at 64; Jason Zweig, How Funds Can
Do Better, MONEY, Feb. 1998, at 42.
---------------------------------------------------------------------------
We have reevaluated our disclosure requirements in light of these
criticisms and have concluded that, while our fundamental approach is
sound, there are several gaps in the information that shareholders
currently receive about directors. Historically, the primary vehicle
for providing information about mutual fund directors was the proxy
statement prepared in connection with shareholder meetings. In recent
years, 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.\149\
---------------------------------------------------------------------------
\149\ See John Nuveen & Co., Inc. SEC No-Action Letter (Nov. 18,
1986) (``Nuveen Letter'') (annual meetings to elect directors not
required by Investment Company Act). The Nuveen Letter took the
position that annual meeting requirements generally are a question
of state law.
For historical and other reasons, most funds are organized under
the laws of Massachusetts or Maryland. The organizational and
operational requirements of Massachusetts business trusts are not
specified by statute, and a fund's essential structure is contained
in the trust agreement, which generally includes a provision
eliminating the need for annual shareholder meetings to elect
directors. See generally Jones, Moret and Storey, The Massachusetts
Business Trust and Registered Investment Companies, 13 DEL. J. CORP.
L. 421 (1988). Under Maryland corporate law, fund charters or by-
laws are not required to provide that annual meetings be held in any
year in which election of directors is not required by the
Investment Company Act. MD. CODE ANN., CORPS. & ASS'NS Code Sec. 2-
501(b) (1999). In addition, Delaware, Minnesota, and California also
have business trust or special corporate law structures that have
the effect of not requiring shareholder meetings other than those
required by the Investment Company Act. DEL. CODE ANN. tit. 12,
Sec. 3806 (1999); Minn. Stat. Sec. 302A.431 (1999); CAL. CORP. CODE
Sec. 600(b) (West 1999).
Closed-end funds registered on national securities exchanges,
however, are required to hold an annual meeting to elect directors
under the rules of the exchanges. See, e.g., American Stock Exchange
Listing Standards, Policies, and Requirements Sec. 704; New York
Stock Exchange Listed Company Manual Sec. 302.00. Closed-end fund
shareholders therefore generally would receive annual proxy
statements.
---------------------------------------------------------------------------
In addition, although mutual funds are required to disclose certain
information that bears on a director's potential conflicts, the SAI
requirements and proxy rules do not require disclosure of other
circumstances that could raise similar conflict of interest concerns,
such as those involving a director's immediate family members. The
current rules also do not require disclosure of information that may
show
[[Page 59840]]
that a director's interests are aligned with shareholder interests,
including a director's securities holdings in funds in the fund
complex.
Therefore, we are proposing amendments to our disclosure rules to
close these gaps. Our proposals would require mutual 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.
These proposals would supplement the information that currently is
available in the mutual fund SAI and in proxy statements. For ease of
reference, we have attached as Appendix A a table cross-referencing the
proposed disclosure requirements in the proxy rules and the SAI of Form
N-1A with existing requirements.\150\
---------------------------------------------------------------------------
\150\ Form N-1A is the registration form used by open-end
management investment companies to register under the Investment
Company Act and to offer their shares under the Securities Act. We
also are proposing parallel changes to Forms N-2 (closed-end funds)
and N-3 (managed separate accounts offering variable annuity
contracts).
---------------------------------------------------------------------------
1. Basic Information About Directors
(a) Location of Information. The Commission is proposing to require
mutual funds to disclose basic information about directors in an easy-
to-read tabular format.\151\ We are proposing to combine in one table
certain information currently required for directors in the SAI and
proxy statements.\152\ This new table would be required in three
places: the fund's annual report to shareholders, SAI, and proxy
statement for the election of directors. This would ensure that the
information is available to prospective investors upon request. It also
would ensure that mutual fund shareholders receive basic information
about the identity and experience of their directors both annually and
whenever they are asked to vote to elect directors.
---------------------------------------------------------------------------
\151\ Proposed Item 22(b)(1) of Schedule 14A; proposed Items
13(a)(1) and 22(b)(5) of Form N-1A; proposed Item 18.1 and
Instruction 4.e. to Item 23 of Form N-2; proposed Item 20(a) and
Instruction 4(v) to Item 27 of Form N-3. For convenience in
discussing the proposed requirements, we are not specifically
referring to nominees for election as directors. The proposed
requirements, however, would be applicable to nominees in proxy
solicitations 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].
\152\ See Item 13(b) of Form N-1A; Item 18.1 to Form N-2; Item
20(a) of Form N-3; Items 401(a) and (e) of Regulation S-K, through
Item 22(b)(4) of Schedule 14A. As currently required, funds would
continue to include in the table information about officers and
advisory board members of the fund, as well as directors. See Items
13(b) of Form N-1A; Item 18.1 of Form N-2; Item 20(a) of Form N-3;
Items 401(b) and (e) of Regulation S-K, through Item 22(b)(4) of
Schedule 14A.
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We are not proposing to require that basic information about
directors be included in the prospectus. We considered, and rejected,
this idea during our recent top-to-bottom overhaul of the mutual fund
prospectus.\153\ At the time of our prospectus overhaul, however, we
directed the Division of Investment Management to consider whether
information about directors should be included in fund annual reports,
and we have now concluded that it should.\154\
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\153\See 1998 Form N-1A Release, supra note 146, at 13930-13931.
\154\ See Id.
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Our proposals would, for the first time, require that basic
information about mutual fund directors be included in the annual
report to shareholders.\155\ Because the proxy statement is no longer
received by most fund shareholders annually, we are proposing to
include basic information about directors in the annual report to
ensure that shareholders will receive it regularly. We also are
proposing to require funds to include in the annual report a statement
that the SAI includes additional information about fund directors and
is available without charge upon request.\156\ The statement must
include a toll-free (or collect) telephone number for shareholders to
call for additional information.
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\155\ Proposed Item 22(b)(5) of Form N-1A; proposed Instruction
4.e. to Item 23 of Form N-2; proposed Instruction 4(v) to Item 27 of
Form N-3.
\156\ Proposed Item 22(b)(6) of Form N-1A; proposed Instruction
4.e. to Item 23 of Form N-2; proposed Instruction 4(vi) to Item 27
of Form N-3.
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We request comment on the appropriate location for basic
information about mutual fund directors. Please address whether basic
information should be included in the prospectus, SAI, annual report,
and/or proxy statement. Should we, for example, reconsider our decision
not to include any of the basic information about directors in the
prospectus?
(b) Required Information. The proposed table would 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.\157\ The table also would require for each
``interested'' director, as defined in section 2(a)(19) of the Act, a
description of the relationship, events, or transactions by reason of
which the director is an interested person.\158\
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\157\ As is currently required, the fund also would be required
to explain any family relationship between the persons listed in the
table. See current Item 401(d) of Regulation S-K, through Item
22(b)(4) of Schedule 14A; Item 13(b) of Form N-1A; Item 18.1 of Form
N-2; Item 20(a) of Form N-3; proposed Item 22(b)(1) of Schedule 14A;
proposed Item 13(a)(1) of Form N-1A; proposed Item 18.1 of Form N-2;
proposed Item 20(a) of Form N-3.
\158\ Proposed Instruction 4 to Item 22(b)(1) of Schedule 14A;
proposed Instruction 2 to Item 13(a)(1) of Form N-1A; proposed
Instruction 2 to Item 18.1 N-2; proposed Instruction 2 to Item 20(a)
of Form N-3.
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Currently, mutual funds must disclose the number of other
registered investment companies in the fund complex that a director
oversees.\159\ The Commission now is proposing to require disclosure of
the total number of portfolios, rather than registered investment
companies, that a director oversees.\160\ In today's environment, where
a complex may choose between organizing a single series company with
multiple portfolios or multiple investment companies each with a single
portfolio, we believe that requiring disclosure of the number of
portfolios that a director oversees would provide a more accurate
picture of the director's responsibilities.
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\159\ See Item 401(e)(2) and Instruction to Item 401(e)(2) of
Regulation S-K, through Item 22(b)(4) of Schedule 14A; Item 13(c)
and Instruction to Item 13(c) of Form N-1A; Item 18.2 and
Instruction to Item 18.2 of Form N-2; Item 20(b) and Instruction to
Item 20(b) of Form N-3.
\160\ Proposed Item 22(b)(1) of Schedule 14A; proposed Item
13(a)(1) of Form N-1A; proposed Item 18.1 of Form N-2; proposed Item
20(a) of Form N-3.
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The Commission seeks comment on whether the proposed basic
information would provide shareholders with sufficient information
about the directors who are charged with protecting shareholder
interests. If the disclosure would not achieve this purpose, is there
other basic information about directors that should be required? If
proposed disclosure of any item is not necessary or useful to
investors, please explain the reason why. Should the same basic
information be included in the SAI, annual report, and proxy statement?
2. Ownership of Equity Securities in Fund Complex
As discussed above, some have complained that shareholders do not
know whether directors' interests are
[[Page 59841]]
aligned with those of shareholders.\161\ Although a director need not
necessarily hold securities of funds in a fund complex to be an
effective advocate for shareholders, the interests of a director who
holds shares in the complex will tend to be aligned with the interests
of other shareholders.\162\ We are therefore proposing to require
disclosure of the aggregate dollar amount of equity securities of funds
in the fund complex owned beneficially and of record by each
director.\163\
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\161\See supra note 148 and accompanying text.
\162\ See Peter McKenna, Mutual Funds Are Built to Last With
Embedded Checks, Balances, Investor's Business Daily, May 1, 1998,
at B4 (quoting fund industry consultant Geoffrey H. Bobroff) (``It's
useful to see how many shares are owned by members of the board. * *
* Most investors like board members to share the fund's risk and
possible reward.'').
\163\ Proposed Item 22(b)(4) of Schedule 14A; proposed Item
13(b)(4) of Form N-1A; proposed Item 18.7 of Form N-2; proposed Item
20(f) of Form N-3.
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We are not proposing to require separate disclosure of a director's
holdings of equity securities in the fund itself. We are concerned that
this information might have limited meaning because of the many reasons
that a director could have for not holding shares of any specific fund,
e.g., that its investment objective did not fill a need in the
director's portfolio.
Funds would provide information on director holdings in an easy-to-
read tabular format including: (1) Name of director; (2) identity of
fund complex; and (3) aggregate dollar amount of equity securities
owned of funds in the complex. The information, as of the most recent
practicable date, would be provided in the fund's SAI and in any proxy
statement relating to the election of directors. This would ensure that
the information is available to prospective investors upon request and
is provided to shareholders whenever they are asked to vote to elect
directors.\164\
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\164\ As noted earlier, supra note 149, closed-end funds are not
required to update their registration statements annually; however,
shareholders would receive the information annually in proxy
statements for the election of directors.
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``Fund complex'' is currently defined in the proxy rules 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.\165\ The Commission is proposing to use this definition to
determine a director's holdings in a fund complex.\166\
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\165\See Item 22(a)(1)(v) of Schedule 14A.
\166\ See proposed Instruction 1(a) to Item 13 of Form N-1A;
proposed Instruction 1.b. to Item 18 of Form N-2; proposed
Instruction 1.a. to Item 20 of Form N-3. The proposed definition of
``fund complex'' also would apply to the proposed disclosure
requirement for basic information about directors. See supra note
157 and accompanying text (proposing to require disclosure for each
director of the number of portfolios overseen within the fund
complex and other directorships held outside of the fund complex).
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We request comment on whether information on director holdings of
shares in a fund complex would be useful to shareholders. If so, should
the Commission use the definition of ``fund complex'' that is currently
contained in the proxy rules? Or should the Commission use another
definition, such as ``family of investment companies'' used in Form N-
SAR? \167\ Should disclosure of director holdings be limited to
holdings in the fund itself, the group of funds overseen by a director,
or some other group of funds? The Commission also requests comment on
whether there is other information that bears on the alignment of
interests of shareholders and directors and should be disclosed.
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\167\ See Item H of Form N-SAR [17 CFR 274.101] (defining
``family of investment companies'' to mean any two or more
investment companies 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);
see also Rule 11a-3 under the Act [17 CFR 270.11a-3] (defining
``group of investment companies'' to mean any two or more open-end
investment companies that hold themselves out to investors as
related companies for purposes of investment and investor services
and that either (1) have a common investment adviser or principal
underwriter or (2) the investment adviser or principal underwriter
of one of the companies is an affiliated person of the investment
adviser or principal underwriter of each of the other companies).
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3. Conflicts of Interest
(a) Statutory Scheme Governing Conflicts of Interest. As described
above, Congress provided that at least 40 percent of the board of
directors of an investment company must be independent and assigned a
special role to the independent directors--to supply a check on
management and act as independent watchdogs for investors.\168\ Under
the Investment Company Act, an independent director is an individual
who is not an ``interested person'' of the fund.\169\
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\168\ See supra notes 20, 22, and 23 and accompanying text.
\169\ See section 10(a) of the Act.
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In section 2(a)(19) of the Act, Congress enumerated individuals who
are ``interested persons'' of a fund and who, therefore, are not
considered independent directors. These individuals include: (1) Any
affiliated person of the fund, (2) any member of the immediate family
of any natural person who is an affiliated person of the fund, (3) any
interested person of any investment adviser of or principal underwriter
for the fund, (4) any person or partner or employee of any person who
at any time since the beginning of the last two completed fiscal years
of the fund has acted as legal counsel for the fund, and (5) any broker
or dealer registered under the Exchange Act or any affiliated person of
a broker or dealer.\170\
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\170\ Sections 2(a)(19)(A)(i)-(v) of the Act [15 U.S.C. 80a-
2(a)(19)(A)(i)-(v)]. Section 2(a)(3) of the Act [15 U.S.C. 80a-
2(a)(3)] defines affiliated person of another person to mean: (1)
any person directly or indirectly owning, controlling, or holding
with power to vote, 5 per centum or more of the outstanding voting
securities of such other person; (B) any person 5 per centum or more
of whose outstanding voting securities are directly or indirectly
owned, controlled, or held with power to vote, by such other person;
(C) any person directly or indirectly controlling, controlled by, or
under common control with, such other person; (D) any officer,
director, partner, copartner, or employee of such other person; (E)
if such other person is an investment company, any investment
adviser thereof or any member of an advisory board thereof; and (F)
if such other person is an unincorporated investment company not
having a board of directors, the depositor thereof.
Section 2(a)(19) of the Act [15 U.S.C. 80a-2(a)(19)] defines
immediately family member to mean any parent, spouse of a parent,
child, spouse of a child, spouse, brother, or sister, and includes
step and adoptive relationships.
Sections 2(a)(19)(B)(i)-(v) of the Act [15 U.S.C. 80a-
2(a)(19)(B)(i)-v] define an interested person of an investment
adviser or principal underwriter of a fund to include: (1) Any
affiliated person of the investment adviser or principal
underwriter; (2) any member of the immediate family of any natural
person who is an affiliated person of the investment adviser or
principal underwriter; (3) any person who knowingly has any direct
or indirect beneficial interest in, or who is designated as trustee,
executor, or guardian of any legal interest in, any security issued
either by the investment adviser or principal underwriter or by a
controlling person of the investment adviser or principal
underwriter; (4) any person or partner or employee of any person who
at any time since the beginning of the last two completed fiscal
years of the fund has acted as legal counsel for the investment
adviser or principal underwriter; and (5) any broker or dealer
registered under the Exchange Act or any affiliated person of a
broker or dealer.
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Congress also gave the Commission authority to determine by order
that a director is an interested person even though he is not covered
by the categories enumerated in the statute.\171\ The Commission may
determine that a natural person is an interested person of a fund by
reason of having had, at any time since the beginning of the last two
completed fiscal years of the fund, a material business or professional
relationship with the fund, the principal executive officer of the
fund, any other investment company having the same investment adviser
or principal underwriter, or the principal executive officer of the
other investment
[[Page 59842]]
company.\172\ We also may determine that a natural person is an
interested person of an investment adviser or principal underwriter of
a fund (and therefore of the fund itself) by reason of having had, at
any time since the beginning of the last two completed fiscal years of
the fund, a material business or professional relationship with the
investment adviser or principal underwriter or with the principal
executive officer or any controlling person of the investment adviser
or principal underwriter.\173\ For example, in appropriate
circumstances, the Commission may find that a director who was an
employee of a fund's investment adviser within the past two years is an
``interested person'' under section 2(a)(19)(B)(vi) of the Act by
reason of having a material business or professional relationship with
the investment adviser.\174\
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\171\ See H.R. Rep. No. 1382, 91st Cong., 2d Sess. 14-15 (1970).
\172\ Section 2(a)(19)(A)(vi) of the Act [15 U.S.C. 80a-
2(a)(19)(A)(vi)]. The statute also provides that no person shall be
deemed an interested person of a fund solely by reason of being a
member of its board of directors or advisory board or an owner of
its securities, or his membership in the immediate family of any
person who is a member of the fund's board of directors or advisory
board or an owner of its securities. Id.
\173\ Section 2(a)(19)(B)(vi) of the Act [15 U.S.C. 80a-
2(a)(19)(B)(vi)].
Section 2(a)(9) of the Act [15 U.S.C. 80a-2(a)(9)] defines
control to mean the power to exercise a controlling influence over
the management or policies of a company, unless such power is solely
the result of an official position with such company. Any person who
owns beneficially, either directly or through one or more controlled
companies, more than 25 percent of the voting securities of a
company shall be presumed to control such company. Any person who
does not own more than 25 percent of the voting securities of any
company shall be presumed not to control such company.
\174\ See Interpretive Release, supra note 1.
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(b) Need for Disclosure Changes. The proxy rules currently require
significant information about conflicts of interest of directors.\175\
The proxy rules require disclosure of positions held with the
investment adviser and any securities holdings or material interests in
the investment adviser and any person controlling, controlled by, or
under common control with the investment adviser.\176\ A mutual fund
also must disclose any material interests of a director in the fund's
principal underwriter or administrator.\177\ In addition, a fund must
disclose any material interests of a director in any material
transactions with the fund, the investment adviser, the principal
underwriter, the administrator, or any person controlling, controlled
by, or under common control with the investment adviser, principal
underwriter, or administrator.\178\
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\175\ See supra note 145 and accompanying text.
\176\ See Item 22(b)(1) of Schedule 14A.
\177\ See Item 22(b)(2) of Schedule 14A.
\178\ See Item 22(b)(3) of Schedule 14A, and Item 404(a) of
Regulation S-K, through Item 22(b)(4) of Schedule 14A.
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We are proposing to enhance the disclosure required in the proxy
rules because we believe that there are other situations that could
involve conflicts of interest. We also are proposing to include the
proposed conflicts disclosure about directors in the SAI because mutual
funds no longer prepare proxy statements on a regular basis.\179\
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\179\ See supra note 149 and accompanying text.
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We believe disclosure of directors' potential conflicts of interest
would serve three purposes. First, this disclosure would bring to the
attention of shareholders circumstances that may affect the directors'
allegiance to shareholders. With this information, shareholders may
decide for themselves whether an independent director has any potential
conflicts of interest that could affect the director's ability to
protect the interests of shareholde
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