As previously anticipated following (1) Commissioner Levitt’s speech before the Investment Company Institute (ICI)/Federal Bar Association on March 22, 1999 (Fund Alert, April 1999), and (2) the release of the Advisory Group on Best Practices for Fund Directors report on June 24, 1999 (Fund Alert, July 1999), the SEC, on October 13, 1999, authorized a rule proposal designed to ensure the independence of independent directors on fund boards.1 They also authorized the issuance of a related interpretive release.2 The proposed rules, which involve the composition and qualifications of fund boards, are intended to give directors the ability to more effectively deal with fund management. The rules are also aimed at providing investors with additional disclosures about director independence, so that an investor may more accurately assess the board’s ability to effectively oversee the fund’s operations.

On the same day, the SEC also announced the formation of the Mutual Fund Directors Education Council. The Council will be chaired by former SEC Chairman, David S. Ruder, and administered by Northwestern University. Initially, its board will consist of prominent members of the investment company industry. The stated purpose of the council is to encourage programs aimed at ensuring independent investment company governance.

Substantive Proposals on Independence

The Investment Company Act of 1940 does not include any specific authority for the SEC to set general standards on directors’ independence. Rather, the SEC has identified ten 1940 Act rules that exempt funds or their affiliated persons from provisions of the 1940 Act and have, as a condition, the approval or oversight of independent directors.3 A majority of funds rely on one or more of these rules to do such things, for example, as adopt 12b-1 plans and maintain joint insured bonds. For funds relying on any of these exemptions:

  • fund boards must be composed of a majority or a two-thirds supermajority of independent directors (it is yet to be determined whether the requirement will be by a simple majority or by a two-thirds supermajority);
  • new independent directors must be selected and nominated solely by those who are currently independent directors; and
  • legal counsel (if any) for the independent directors may not have also represented the fund’s investment adviser, principal underwriter, administrator, or any of their control persons for the prior two years, unless the independent directors determine that the representation is, or was, so limited that it would not adversely affect counsel’s ability to provide impartial, objective, and unbiased legal counsel.

The SEC is aware that retaining separate legal counsel could be a substantial expense for smaller funds, and is therefore not proposing a requirement that legal counsel actually be retained. The independence standard applies only if separate counsel is, in fact, retained. Nevertheless, the legal counsel requirement is probably the most controversial of the proposals, and Commissioner Johnson stated his strong concerns about it at the October 13 open meeting.

Disclosure Proposals

Funds would also be required, under the proposed rules, to provide specific disclosure concerning the background and qualifications of fund directors. Specifically, for each director the fund must disclose:

  • identity and business background;
  • share ownership in the fund;
  • potential conflicts of interest; and
  • the board’s role in governing the fund.

The annual report should contain a summary of this disclosure. The disclosure requirements, particularly the determination that none of these disclosures need to be made in the prospectus, were the subject of considerable discussion at the SEC open meeting. The Commissioners and staff indicated a strong interest in reviewing public comments on this topic.

Other Rule Proposals

The proposed new rules and rule amendments would also:

  • prevent qualified individuals from being unnecessarily disqualified from serving as independent directors simply because they invest in index funds that hold shares of the fund’s adviser or other affiliates4;
  • protect the independence of independent directors by requiring that joint "errors and omissions" insurance policies cover lawsuits brought against them by investment advisers;
  • encourage the development of independent audit committees by exempting funds that have implemented such committees from seeking shareholder approval of the fund's auditor; and
  • require funds to maintain the records used to assess the independence of independent directors.

Interpretive Matters Related to Independent Directors

The Commission has also issued an interpretive release, expressing the views of the Commission’s staff on matters related to independent directors. The release:

  • provides guidelines on the types of material business and professional relationships that might disqualify a director from serving as an independent director of a fund;
  • states that actions taken by fund directors, acting in the capacity of directors, generally do not constitute "joint transactions" that require prior SEC approval;
  • provides guidance regarding situations where funds may advance legal fees to their directors; and
  • makes more liberal the circumstances under which funds may compensate fund directors with fund shares.

The Interpretive Release also discusses the SEC’s views regarding its role in and response to disputes between fund independent directors and fund management, involving allegations of federal securities laws violations.

Comments on the rule proposals are due by January 28, 2000. The views in the interpretive release were effective upon its publication.

 

1 Role of Independent Directors of Investment Companies, Release

Nos. 33-7754, 34-42007, IC-24082, Fed. Reg. (Oct. 14, 1999).

2 Interpretive Matters Concerning Independent Directors of Investment Companies, Release No. IC-24083, Fed. Reg. (Oct. 14, 1999).

3 Rules 10f-3, 12b-1, 15a-4, 17a-7, 17a-8, 17d-1(d)(7), 17e-1, 17g-1(j), 18f-3, and 23c-3.

4 The proposed rule would not address an independent director’s ownership of securities of an actively managed fund, because holdings of such funds can vary without the knowledge of shareholders, and the SEC therefore believes that investors ordinarily would not "knowingly" have an indirect beneficial interest in the actively managed fund's holdings. Release No. 33-7754, __ Fed. Reg. at __ n.140.

Securities and Investment Company Department

John M. Baker 202-261-3512

Jana L. Cresswell 215-564-8048

Diane J. Drake 215-564-8067

Lisa A. Duda 215-564-8143

Steven M. Felsenstein 215-564-8074

Robert K. Fulton 215-564-8042

Alan R. Gedrich 215-564-8050

Nadia M. Jannetta 215-564-8014

Lisa M. King 215-564-8077

Stephen W. Kline 610-640-5801

Duane L. Lassiter 215-564-8010

Bruce G. Leto 215-564-8115

Lisa L. B. Matson 215-564-8003

Barbara A. Nugent 215-564-8092

Michael P. O’Hare 215-564-8198

Mark H. Plafker 215-564-8024

Mark A. Sheehan 215-564-8027

Merrill R. Steiner 215-564-8039

Bibb L. Strench 202-261-3580

Sinclair A. Ziesing 215-564-8055

Fund Taxation

Zachary P. Alexander 215-564-8043

Rekha D. Packer 215-564-8096

William S. Pilling, III 215-564-8079

William P. Zimmerman 215-564-8124

ERISA

John J. Hunter 215-564-8072

James F. Podheiser 215-564-8111

Fund Banking Issues

David F. Scranton 610-640-5806

Delaware Business Entity Issues

Sheela P. Dattani 302-576-5852

Ellisa Opstbaum Habbart 302-576-5851

 

Other offices in:

Malvern, Pennsylvania

Wilmington, Delaware

Cherry Hill, New Jersey

Washington, DC

Information contained in this publication should not be construed as legal advice or opinion, or as a substitute for the advice of counsel. The enclosed materials may have been abridged from other sources. They are provided for educational and informational purposes for the use of clients and others who may be interested in the subject matter.