Role of Independent Directors of Investment Companies; SEC File No. S7-23-99January 27, 2000
Jonathan G. Katz, Secretary
U.S. Securities and Exchange Commission
450 Fifth Street, N.W.
Washington, DC 20549
RE: Role of Independent Directors of Investment Companies; SEC File No. S7-23-99
Dear Mr. Katz:
This letter is submitted in response to a request for comment by the Securities and Exchange Commission (the "Commission") on proposed regulatory changes that are intended to enhance the independence and effectiveness of investment company directors and to better enable investors to assess the independence of directors. The proposed changes were published in Release Nos. 33-7754, 34-42007 and IC-24082 (Oct. 14, 1999) (the "Proposing Release").
This letter is submitted by the Subcommittee on Investment Companies, Section of Business Law of the Philadelphia Bar Association (the "Subcommittee"). In general, the Subcommittee supports the goals of the Commission as articulated in the Proposing Release. This letter, however, addresses three issues raised by the Proposing Release that give the Subcommittee concern:
1. Modification of specific statutory board composition requirements should be accomplished by congressional action and not by administrative rulemaking.
2. The Commission's proposal to regulate attorney/client relationships is unprecedented, and intrudes upon an area of historical and comprehensive state oversight.
3. The Commission's public disclosure proposals are overbroad and, in certain significant respects, do not seem intended to ensure that investors have material information for their investment decisions, but instead seem intended as a discovery device to assist the Commission in its examination functions. The disclosure proposals raise substantial privacy concerns.
These three issues are discussed further below.
- Modification of specific statutory board composition requirements should be accomplished by congressional action and not by administrative rulemaking.
The history of the Investment Company Act of 1940 (the "Investment Company Act") makes clear that the structure of investment company boards and board composition requirements relating to independent directors are established by congressional action and not by administrative rulemaking.
As originally enacted in 1940, the Investment Company Act contained specific provisions as to the structure of fund boards in Section 10 and the independence of directors in the definition of "affiliated person" in Section 2(a). These sections clearly demonstrated congressional intent that issues relating to the structure of fund boards were to be dealt with by legislation and were not delegated to the Commission for rulemaking.
In 1970, Congress again considered the structure of fund boards when it amended Section 2(a) and Section 10 of the Investment Company Act to refine its categorization of directors as "interested" and "non-interested" directors.
In 1975, Congress again considered fund board governance in the context of enacting Section 15(f) of the Investment Company Act to deal with adviser acquisitions with the requirement that 75% of a fund's board be "non-interested" for a period of time.
In 1995, Congress considered a bill that would have amended Section 10(a) of the Investment Company Act to require fund boards to have at least a majority of independent directors. Congress did not enact this bill despite congressional testimony from the then Director of the Commission's Division of Investment Management (the "Division"), Mr. Barry Barbash, supporting the legislation.
Most recently, in November 1999, Congress enacted the Gramm-Leach-Bliley Act which amends Section 2(a) and Section 10 of the Investment Company Act with respect to the qualification and status of directors who are affiliated with banks and broker/dealers.
In the Proposing Release, the Commission acknowledges that the board composition requirements in the Investment Company Act have been the subject of careful congressional consideration. In particular, the Commission states in footnote 37 of the Proposing Release:
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. § 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).
Again, in a 1992 report on investment company regulation, the Commission's Division indicated its belief that modification to board composition requirements required congressional action, when the Division recommended that "the Commission recommend legislation that would increase the minimum proportion of independent directors on investment company boards from forty percent to more than fifty percent."
Notwithstanding this precedent, however, the Commission now believes that it may effectively accomplish the same result by amending ten of its rules that are used by approximately ninety percent of all registered investment companies (referred to as the "Exemptive Rules"). Specifically, as amended, the Exemptive Rules will require that for any fund that relies on any of these rules, a majority, rather than forty percent, of the fund's directors must be independent.
We believe that the Proposing Release sets forth the following: (a) the Commission disagrees with the judgment of Congress regarding the composition of fund boards (see footnote 37 of the Proposing Release (last two sentences)); (b) because the Commission cannot directly change the provisions of the Investment Company Act, the Commission proposes to accomplish the same result indirectly by making its own desired board composition requirement a condition to the Exemptive Rules; and (c) the primary objective the Commission seeks to achieve through this action is substantially unrelated to the operation or effectiveness of the Exemptive Rules it proposes to amend. In this last regard, the Commission has not cited any instance where the purposes of the Exemptive Rules have failed because a fund complied with the statutory board composition requirements rather than those proposed by the Commission. This is so even though some of the Exemptive Rules were originally adopted more than thirty years ago, and only two of these Rules have been adopted within the last ten years.
Rather, the Commission's principal objective is to enhance the independence of independent fund directors generally on all fund governance matters, and the proposed amendments to the Exemptive Rules regarding board composition are simply the vehicle to achieve this objective. (See, for example, the text of the Proposing Release following footnote 44: "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.")
We do not question the good intentions of the Commission. Nor do we necessarily disagree with the Commission's view that its proposed board composition requirement is desirable as a matter of policy. We believe, however, that this aspect of the Commission's proposal implicates considerations relating to the Commission's jurisdictional limits that are at least as important as the federal regulation of fund governance and likely exceeds the Commission's legal rulemaking authority under the Administration Procedure Act and federal securities laws.
In particular, we believe that the Commission must delve further into the question of whether it has the legal power to adopt its proposed board composition requirement (a matter which we seriously question). Furthermore, even if it can be seriously argued that such legal power exists, we believe it is still questionable whether the Commission should exercise such power in light of both the repeated (and recent) actions of Congress in this area and the historical reluctance of Congress to create a federal corporate law that overrides state law with respect to the chartering and governance of business entities. When Congress has addressed these issues in the past, it has done so only after full congressional consideration and only in the context of the Constitutional process relating to the enactment of statutes. The Commission's proposed rulemaking process is, quite simply, not subject to the same safeguards that apply to the legislative process, and is less likely to ensure that the careful balance achieved by Congress will be preserved with respect to the regulation of investment companies under federal and state law.
The Commission has not addressed any of these matters in the Proposing Release and, for the reasons stated above, we believe that the Commission should defer to Congress regarding board composition requirements.
- The Commission's proposal to regulate attorney/client relationships is unprecedented, and intrudes upon an area of historical and comprehensive state oversight.
The regulation of the conduct of the legal profession generally, and attorney/client relationships specifically, is an area of historical and comprehensive state oversight. Canons of ethics adopted by State Supreme Courts have put the interests of clients ahead of lawyers, and have regulated with great care a lawyer's concurrent representations of clients with differing interests.
In Pennsylvania, for example, the current embodiment of these standards is found in Rule 1.7 of the Rules of Professional Conduct adopted by the Supreme Court of Pennsylvania. Rule 1.7 provides that a lawyer, without client consent, may not take on a representation directly adverse to a present client nor may the lawyer take on a representation where the representation of that client will be materially limited by the lawyer's responsibilities to another client. If either of these conflicts is identified, the lawyer must ask whether, notwithstanding the conflict, a reasonable lawyer would conclude that taking on the conflicting representation would not adversely affect the relationship with the existing client. Only if that question can be answered in the affirmative may the lawyer seek the informed consent of the affected clients to the conflict of interest. Otherwise, the representation may not be undertaken.
Similar rules governing conflicts of interest have been adopted by virtually every State Supreme Court and, by all accounts, these rules have served the legal profession, and, far more importantly, clients, very well.
These rules reflect a careful balancing between what, on the one hand, might seem, as a superficial matter, the desirability of securing separate representation for every party to a transaction or a litigation matter with, on the other hand, the avoidance of the costs and inefficiencies that come with separate representation for each party in those common situations in which lawyers may undertake concurrent and/or joint representations of parties with conflicting interests with informed consent for the mutual benefit of all.
Now the Commission proposes to amend the Exemptive Rules (as defined above) to require, for funds that rely on those Rules, that whenever a fund's independent directors seek legal advice, they must retain "independent counsel" as defined by the Commission's regulations. These regulations will establish which counsel will and will not qualify to act as the lawyer for the independent directors.
While the Commission asserts that it is not its intention to regulate the practice of law, even a cursory review of its proposal demonstrates that this is precisely what will occur if the proposal is adopted. Instead of the existing state regulation of lawyer conflicts of interest, in the investment company context a new set of federally mandated rules will apply. These rules will directly interfere with the ability of counsel to provide what would otherwise be viewed as perfectly appropriate joint representation, will prohibit counsel from seeking informed consent to conflicting representations where the lawyer rules of professional conduct would permit such waivers, and will bar the independent directors from seeking advice from a whole class of attorneys who otherwise would be able to do so under current professional rules, often at significant savings in fees and with considerably more efficiency. In other words, in the name of regulating client conduct, the Commission, in effect, would be amending the rules of professional conduct.
We share the Commission's view that the independent directors of every fund should have access to independent legal counsel as a source of objective and accurate information. It is clear, however, that the current regulatory framework does nothing to hinder independent directors from selecting and retaining counsel of their own choice.
For the following reasons, we believe strongly that the Commission's independent counsel proposal should not be adopted.
First: Usurpation Of State Regulation. The Commission's proposal usurps the traditional role of the individual states in governing the professional responsibilities of lawyers. This is not a minor principle. Just recently, in another but similar context, Congress reaffirmed, in the so-called McDaid-Murtha amendment, the fact that Justice Department lawyers must abide by state rules of ethical conduct. 28 U.S.C. § 530B. For the same reasons that provided the impetus for the passage of the McDaid-Murtha amendment, the Commission should only enter this area if there is a compelling need for that approach. But, in fact, all of the evidence is to the contrary. The Commission has not identified any instance in which state regulation of the attorney/client relationship in fund governance matters has been inadequate and that would justify the Commission's unprecedented proposal to regulate those relationships.
Second: No Particular Expertise. We do not believe that the Commission has any particular expertise in regulating attorney/client relationships. In contrast to state bodies that have oversight of these relationships, this is clearly not a primary responsibility of the Commission. The Commission's experience in this area is primarily limited to proceedings under Rule 2(e) of its Rules of Practice that may be brought to deny a person's privilege of appearing or practicing before the Commission if certain findings are made. These proceedings, which have been rare, relate to the conduct of specific attorneys in specific factual contexts. In contrast, the Commission's current proposal to disqualify an entire class of attorneys from representing an entire class of clients is unprecedented.
Third: Directors Are In A Better Position To Determine Impartiality. The Commission appears to believe that, as a federal agency, it is in a better position than independent directors to determine whether their legal counsel can give impartial, objective advice. We disagree categorically with the Commission's assumption, and believe further that, with its limited resources, it is impossible for the Commission to provide effective oversight over the innumerable types of factual patterns that can arise with respect to the relationships between independent directors and their counsel in an industry as large and diverse as the fund industry.
Fourth: Independent Directors Are Capable Of Making Informed Decisions. Where a conflict of interest is present, it is counsel's duty to identify the nature of the conflict and explain it fully to the client and, in those instances where the conflict may be waived, ensure that the client makes an informed choice whether to waive it. Individuals far less sophisticated than independent directors of funds regularly are asked to make, and intelligently make, decisions to waive similar conflicts for many reasons, including their confidence in the abilities of their chosen counsel and the efficiencies that come with joint representations. Examples abound. So long as independent directors of funds recognize that they are always free to hire alternative counsel, there is no reason to assume that they are not fully capable of making such judgments.
Fifth: The Commission's Proposal Is Overbroad. The Commission's proposal is premised on a notion that there is always a conflict of interest between the independent directors and a fund's adviser (and other service providers). This is clearly not the case. Frequently, in matters that come before fund boards and on which independent directors are required to act, there is no conflict whatsoever. Starting from its faulty premise, however, the Commission's proposal requires that any time the independent directors seek legal advice they must turn to counsel that is independent as defined by the Commission. This clearly cannot and should not be the rule. For those situations in which the interests of the adviser and the independent directors are aligned, there is every reason for the fund to have the benefit of the advice of the adviser's legal counsel, without incurring any additional expense in seeking other professional assistance.
More importantly, however, the sweep of the Commission's proposal lacks any reasonable nexus to the Exemptive Rules to which the proposal relates. The Exemptive Rules relate to specific matters that would otherwise be prohibited by the Investment Company Act. The Commission's proposal is not, however, limited to the retention of independent counsel on the specific matters that the Exemptive Rules address. Rather, the proposal requires that if a fund relies on any Exemptive Rule, then counsel to the independent directors on any matter (whether or not the matter relates to an Exemptive Rule) must be "independent." Furthermore, the Proposing Release indicates that the Commission is concerned more with transactions that do not involve any of the Exemptive Rules than transactions that do, and that the proposal merely uses the Exemptive Rules to regulate the retention of counsel in situations that the Commission could not otherwise regulate. Thus, as an example, the Commission states in the Proposing Release that it is "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." We believe that it is inappropriate for the Commission to impose conditions to the Exemptive Rules that are not reasonably related to the purposes of those Rules.
Sixth: The Focus Of The Commission's Proposal Is Misdirected. A principal focus of the Commission in fund governance matters should be the assistance of independent directors in fulfilling their responsibilities. The advice of legal counsel can often be useful in this regard. However, in imposing federally mandated independent counsel requirements, and in requiring that the basis for determining that counsel is independent be reflected in a fund's records, the Commission's proposal redirects the focus from the independent directors' fulfillment of their responsibilities to the independence of their legal counsel. Thus, instead of being a means of assisting independent directors in fulfilling their responsibilities, the selection of legal counsel becomes a separate issue that is subject to outside inquiry by the Commission and, potentially, private litigants. This misdirection of regulatory focus is undesirable because: (a) it will discourage independent directors from seeking advice from counsel who may be the best informed and most experienced and, under applicable professional codes of conduct, fully capable of giving the advice, but who may not be independent under the Commission's categorical regulations; and (b) it intrudes upon the confidential relationship between a client and his or her attorney by opening to retrospective examination by outside parties issues (which do not exist today) relating to whether the client's selection of counsel has satisfied regulatory criteria.
Seventh: Lack Of Accurate Cost Estimates. In the Proposing Release, the Commission states that independent directors who are represented by counsel who do not meet the proposed independence standards will be required to retain different counsel if their funds choose to rely on any of the Exemptive Rules. The Commission also states that it has no reasonable basis for determining whether this substitution of counsel is likely to cause the independent directors' cost of legal counsel to increase. (See the text of the Proposing Release at fn. 249.) The Commission later assumes that approximately 1,065 funds will be required to make specified determinations regarding the independence of counsel for their independent directors (because counsel represents in some manner the fund's adviser or other designated service providers), and that the total annual cost to funds in this regard will be $70,505. (See the text of the Proposing Release at fn. 256.)
Although the Commission states that it is sensitive to the costs and benefits imposed by its rules, it concedes that the costs relating to its proposal on independent counsel are unknown. These costs will clearly exceed $70,505 annually since, as the Commission acknowledges, "the services of counsel do not come without cost." (See the text of the Proposing Release at fn. 82.) For the sake of argument, we might suppose that the 1,065 funds mentioned above will not only be required to make the specified determinations described, but may also be required not merely to "substitute" counsel for the independent directors, but to retain separate new counsel to represent them. We might further suppose that the average annual retainer for each separate counsel will be $25,000, which is by no means exorbitant for effective, experienced counsel. Under these assumptions the total annual industry cost of the Commission's proposal will exceed $26 million.
Although we do not know, any more than the Commission does, what the costs of the Commission's proposal on independent counsel will be, we are certain that the cost will far exceed $70,505. We believe, therefore, that before the Commission even considers adopting a proposal of this sort, it should gain a better understanding of the costs.
In conclusion, for each of the reasons discussed above, we believe that the Commission's proposal regarding independent counsel should not be adopted.
- The Commission's public disclosure proposals are overbroad and, in certain significant respects, do not seem intended to ensure that investors have material information for their investment decisions, but instead seem intended as a discovery device to assist the Commission in its examination functions. The disclosure proposals raise substantial privacy concerns.
We believe that the Commission's public disclosure proposals are overbroad in the following respects, which are discussed further below: (a) the proposals require new, complex and immaterial disclosure regarding a director's "immediate family members"; (b) the proposals require detailed financial disclosures relating to a director's non-fund financial investments; and (c) the proposals apply the same disclosure requirements to both independent and non-independent directors.
Immediate Family Members. We believe that the principal purpose of disclosure requirements for registration statements filed under the Securities Act of 1933 and the Investment Company Act is to provide investors with information that is material to their investment decisions. Similarly, we believe that the purpose of disclosure requirements for proxy materials filed under the Securities Exchange Act of 1934 is to provide shareholders with information that is material to their voting decisions. We do not believe that the purpose of these disclosure requirements is to serve as a discovery device to assist the Commission in its examination of investment companies. However, this seems to be a primary purpose of some of the Commission's disclosure proposals relating to conflicts of interest.
In particular, the Commission proposes to implement a new and complex set of disclosure requirements regarding potential conflicts of interest that in many cases will have no relevance to investors. The complexity of the Commission's proposals is shown by the following tables, which set forth: (a) the persons covered by the proposals ("Covered Persons"); (b) the persons related to a fund that may present a potential
conflict ("Related Persons"); and (c) the types of relationships between Covered Persons and Related Persons requiring disclosure.
Persons Covered by the Proposed Conflicts Disclosure
6. Mothers- and
7. Sons- and
8. Sisters- and
(Step and Adoptive Relationships Are Included)
Persons Related to a Fund that May Present a Potential Conflict
Company with the
Adviser or Principal
Executive Officer of
the Fund, its
with the Same
6. Administrator or
a Person Controlling
7. Person Controlled
by or under
with the Fund's
Company with the
as the Fund
9. Another Investment Company with an
Investment Adviser, Principal Underwriter
or Administrator that Controls, Is
Controlled by or Is under Common Control
with an Investment Adviser, Principal
Underwriter or Administrator of a Fund
10. Any Officer of (a) a Fund; (b) the
Investment Adviser, Principal Underwriter
or Administrator of a Fund; (c) a Person
Controlling, Controlled by or under
Common Control with a Fund's Investment
Adviser, Principal Underwriter or
Administrator; (d) an Investment Company
with the Same Investment Adviser,
Principal Underwriter or Administrator as
the Fund; or (e) an Investment Company
with an Investment Adviser, Principal
Underwriter or Administrator that Controls,
Is Controlled by, or Is under Common
Control with an Investment Adviser,
Principal Underwriter or Administrator of a
Types of Relationships Requiring Disclosure
3. Transactions and
We believe that it is apparent that these proposed disclosure requirements, which go far beyond the Commission's current requirements for proxy statements, cover relationships that are of no material relevance to an investor, particularly with respect to directors already identified as "interested" for other reasons. For example, why would an investor be interested that an officer of an affiliate of an investment adviser serves as the director of a company of which the brother-in-law of a fund director is an officer? Indeed, what is the potential conflict-of-interest in this situation? Or why would an investor be interested that the adult step-son of a fund director owns securities of a public company that controls the fund's adviser? Or why would an investor be interested that the sister of a fund director is an employee of the fund's administrator? The list of similar questions is virtually endless, and the answer is the same: The Commission's conflict-of-interest proposals involve a dragnet approach to disclosure that will require funds to provide disclosure about persons who are personally unrelated to the funds and about whom investors have no interest.
Moreover, the Commission's cost estimates to implement its proposed disclosure requirements are substantial and, we believe, probably understated. In particular, the Commission does not explain why it believes that the cost burden for funds to gather the information required by its proposals will increase by only one third (see text of the Proposing Release at fn. 267) when the persons about whom information is required (all immediate family members as identified above) have increased by an indeterminable number. In addition, the complexity and breadth of the Commission's proposed disclosure requirements will expose funds to extra, unnecessary litigation risks for failing to uncover or accurately disclose the required information.
Furthermore, the Commission's proposals will require funds to gather this information from persons who will often have no personal incentive to share the information and, indeed, may have good and legitimate reasons for not sharing it. Again, to use an example, the sister of a fund director may legitimately believe that her ownership of securities issued by companies affiliated with a fund's adviser is her private business and not a matter that should be of public interest. In such a situation, neither the fund director, the fund nor the Commission could compel the sister to disclose her holdings. Similarly, a brother-in-law of a fund director may have a pending business transaction with an affiliate of the fund's adviser that is entirely unrelated to the fund. The brother-in-law may legitimately believe, however, that public disclosure of the transaction will place him at a competitive disadvantage in his business.
Financial Disclosure. Similar but somewhat different concerns arise in connection with the Commission's proposal to require specific information about the securities issued by a fund's investment adviser, principal underwriter or administrator (or their affiliates) that a director owns beneficially or of record. This required information will include the value of the securities that are owned.
Clearly, investors have an interest in knowing which directors of a fund are non-independent. Investors, however, have no more interest in knowing the value of a director's securities holdings in an adviser than investors have an interest in knowing a director's financial worth. The issue here is entirely different than the issues presented by the Commission's proposal to require disclosure of a director's investments in a fund complex. Disclosure of a director's fund investment is arguably relevant to an investor because the investment may show that the director's financial interests are aligned with the investor's interests. In contrast, once disclosure is made that a director owns securities issued by the fund's adviser, principal underwriter or administrator (or their affiliates), the director's conflicting interest is known. Any additional disclosure regarding the amount of the director's investment serves no purpose other than financial voyeurism, and potentially intrudes upon the legitimate business interests of the director and others in keeping this information private. For example, a director who is also the sole shareholder of a fund's adviser may have sound business reasons for not wanting to place a public valuation on his or her privately-owned business. Similarly, an adviser that is a public company may have valid business reasons for not wanting the size of the ownership positions of its employees (whether large or small) to be a matter of public record.
Persons Covered By Disclosure Requirements. The Commission has requested comment regarding the appropriateness of its proposals that will require more conflict-of-interest disclosure by all directors. The proposals require both independent and non-independent directors to disclose: (a) positions held with a fund and persons related to the fund; (b) interests of each director, including securities holdings, in entities related to the fund; and (c) transactions and relationships, including cross-directorships, with the fund and persons related to the fund. We believe that these proposals are particularly overbroad in that they apply the same disclosure requirements to both the independent and non-independent directors of a fund. If a director is non-independent because he or she is employed by a fund's adviser, why is it material for investors to know whether the director's immediate family members also have interests in the
adviser? Or to know whether the non-independent director has other material relationships with the adviser (such as consulting or other relationships)?
Because of the issues discussed above, we believe that the Commission should narrow the scope of its conflicts disclosure. We believe further that the interests of investors in this regard will be served if the Commission: (a) continues to use the conflicts disclosure requirements that are part of its current proxy rules; and (b) applies those rules to the disclosure required in a fund's statement of additional information.
The Subcommittee thanks the Commission for this opportunity to express its views. We are prepared to meet and discuss these matters with the Commission and its staff and respond to any questions.
Michael P. Malloy
Co-Chair, Subcommittee on Investment Companies
John M. Zerr
Co-Chair, Subcommittee on Investment Companies
Audrey C. Talley
Chair, Business Law Section
cc: The Honorable Chairman Arthur Levitt
Commissioner Paul R. Carey
Commissioner Isaac C. Hunt, Jr.
Commissioner Norman S. Johnson
Commissioner Laura S. Unger
Senator Rick Santorum
Senator Arlen Specter