United States: New Rules And Best Practices Forthcoming For Independent Directors

by Bibb L. Strench, Esquire

On March 22, 1999, SEC Chairman Arthur Levitt announced that the SEC would soon propose new rules affecting independent directors. The announcement was made at the Investment Company Institute (ICI)/ Federal Bar Association Mutual Funds and Investment Management Conference in Palm Desert, California. At the same conference, the ICI announced the formation of an advisory group, comprised of various industry representatives that will be working to develop best practices for independent directors. Both initiatives originated at the SEC Roundtable on the Role of Investment Company Independent Directors Roundtable held on February 23-24, 1999, in Washington, D.C.

Mr. Levitt announced that the SEC would soon propose four rules that, if adopted, would require:

1. A majority of an investment company’s directors to be independent directors (i.e., directors who are not interested persons of the investment company).

2. New independent director candidates to be nominated only by a committee consisting of current independent directors.

3. Independent directors to retain outside counsel, which could not also represent the investment company’s adviser.

4. Disclosure of certain information regarding the nature of each independent

director’s independence as provided in the investment company’s statement of additional information.

The SEC held out the possibility that additional rulemaking may be needed in this area. For example, the SEC expressed concern about the exclusion in many director insurance policies of lawsuits brought by co-insureds (e.g., the investment company’s adviser). The SEC is also uneasy about potential conflicts of interest presented when an independent accounting firm audits an investment company while accountants at the same firm serve as consultants to the investment company on compliance and other issues.

The ICI’s Advisory Group for Independent Directors will develop a list of industry best practices by examining how independent directors function and how they are supported at various mutual fund complexes. Best practices are being developed to address areas that the SEC does not believe should be regulated by specific rules. Clues to the areas likely to be addressed can be found in the topics discussed at the Roundtable.

The purpose of the Roundtable was to find ways to strengthen the role of independent directors in the governance of investment companies. The Roundtable was comprised of a series of nine panels made up of independent fund directors, attorneys, academics, investment adviser officers, and consultants. The panels discussed the following major topics relating to independent directors: negotiating fees and expenses, fund distribution, fund brokerage, valuation and liquidity of securities, acquisition of advisers, closed-end funds, bank funds, variable insurance products, and the general effectiveness of directors.

Role of Independent Directors

No consensus was reached on the role independent directors should play in investment company governance. Ronald Gilson, a leading securities law professor, posited that investment company independent directors have three distinct roles:

Other panelists expressed the belief that the primary function of independent directors was to monitor and address conflicts of interest between the investment company and the adviser. According to one panelist, the independent directors need to serve as a check on the adviser’s self interest, which views the investment company as a product to sell and its shareholders as customers. The independent directors therefore must scrutinize adviser initiatives, the purpose of which may be to advance its business and economic interests.

Fee Negotiations

The uncertainty about the role of the independent director was perhaps best highlighted by the panel discussion on the role of independent directors during fee negotiation. At one extreme were those who believe that independent directors are merely an outer check to ensure that fees are reasonable, i.e., they fall within an acceptable range of fees established for the fund’s peer group. At the other extreme are those who expressed the opinion that the independent directors must serve as bargaining agents for the investment companies they represent. Under this approach, they must bargain as a company would bargain with a supplier of raw materials. The SEC stated that it is not likely to propose any new rules governing this process, such as the introduction of additional factors that must be considered by the independent directors.

12b-1 Plans

Most panelists agreed that Rule 12b-1 under the 1940 Act should be amended to update the factors directors must consider when approving a Rule 12b-1 fee. Some panelists advocated new factors. Others said that the factors should be eliminated from Rule 12b-1 since they distract directors from the more important issues raised by the Rule 12b-1 fee. Many panelists were also alarmed by a recent SEC no-action letter. The letter stated that the SEC is taking a hard look at whether pure no-load investment companies should have a Rule 12b-1 plan when they are engaged in activities that are traditionally viewed as administrative, but that arguably could be viewed as distribution-related. Some concern was also expressed about fund supermarkets, especially the inability of fund directors and funds themselves to have any power to negotiate the fees charged by major supermarket purveyors.

Brokerage

Soft-dollar practices received little criticism, although the SEC continued to stress the importance of fully informing independent directors about a fund’s brokerage practices. There was a general consensus that funds were obtaining the best execution while also obtaining research products that are useful to their portfolio managers and analysts. The SEC indicated an interest in the amount paid by investment companies to obtain shelf space at broker-dealers and the process by which a particular investment company is added to a broker’s preferred list.

Closed-End Funds

Panelists addressed the issue of when independent directors should recommend open-ending closed-end funds. Shareholders who have held shares of a closed-end fund for a lengthy period favor remaining a closed-end fund because they want to continue their investment and do not want to pay a capital gains tax. Arbitrageurs who recently acquired a stake in the same closed-end fund favor open-ending or liquidating the fund. One suggestion was to adopt a rule allowing a 12b-1-type fee for closed-end funds to encourage broker-dealers to continue to provide information about the fund and support its shareholders.

Bibb L. Strench is Of Counsel in the Securities and Investment Company Practice of the law firm of Stradley, Ronon, Stevens & Young, LLP. Mr. Strench resides in the firm’s Washington D.C. office.