[Federal Register Volume 64, Number 212 (Wednesday, November 3, 1999)]
[Rules and Regulations]
[Pages 59877-59886]
From the Federal Register Online via the Government Publishing Office [www.gpo.gov]
[FR Doc No: 99-27443]



  Federal Register / Vol. 64, No. 212 / Wednesday, November 3, 1999 / 
Rules and Regulations  

[[Page 59877]]



SECURITIES AND EXCHANGE COMMISSION

17 CFR Part 271

[Release No. IC-24083]


Interpretive Matters Concerning Independent Directors of 
Investment Companies

AGENCY: Securities and Exchange Commission.

ACTION: Statement of Staff Position.

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SUMMARY: The Securities and Exchange Commission is publishing the views 
of the Commission and its staff concerning certain issues under the 
Investment Company Act of 1940 that are related to the independent 
directors of registered investment companies.

EFFECTIVE DATE: October 14, 1999.

FOR FURTHER INFORMATION CONTACT: Mercer E. Bullard, Assistant Chief 
Counsel, or Alison M. Fuller, Assistant Chief Counsel, at 202-942-0659, 
in the Office of Chief Counsel, Division of Investment Management, or 
by writing to the Office of Chief Counsel, Division of Investment 
Management, Securities and Exchange Commission, 450 5th St., NW., 
Washington, DC 20549-0506.

SUPPLEMENTARY INFORMATION:

Executive Summary

    Management investment companies are governed by a board of 
directors, at least 40% of whom must not be ``interested persons'' of 
the company under section 2(a)(19) of the Investment Company Act of 
1940 (the ``Act'') (i.e., ``independent directors'').\1\ Independent 
directors of registered investment companies (``investment companies'' 
or ``funds'') play a critical role in overseeing the funds operations 
and protecting the interests of their shareholders. Today, in a 
companion release,\2\ the Commission is proposing to amend a number of 
rules and forms as part of a broad initiative to enhance the 
effectiveness of independent directors. Simultaneously, the Commission 
is publishing this release, which contains the views of its staff 
concerning a number of interpretive issues under the Act that relate to 
independent directors, and briefly describes the role of the Commission 
in connection with certain disputes between independent fund directors 
and fund management.
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    \1\ 15 U.S.C. Sec. 80a-10(a).
    \2\ Role of Independent Directors of Investment Companies, 
Investment Company Act Release No. 24082 (Oct. 14, 1999) 
(``Companion Release'').
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    Following some general background on the role and duties of fund 
directors, this release addresses the following interpretive topics:
     Section 2(a)(19) of the Act authorizes the Commission to 
issue an order finding that a person is an ``interested person'' due to 
a material business or professional relationship with a fund or certain 
persons or entities. This release provides guidance from the staff 
about the types of business and professional relationships that may be 
material for purposes of section 2(a)(19).
     Some have argued that, if fund directors take an action on 
behalf of the fund that benefits themselves, the action may constitute 
a ``joint transaction'' under section 17(d) of the Act and rule 17d-1 
thereunder, thereby requiring prior Commission approval. This release 
explains the view of the staff that actions taken by fund directors 
within the scope of their duties generally would not be ``joint 
transactions.''
     Some have questioned when a fund may pay an advance of 
legal fees to its directors consistent with section 17(h) of the Act, 
which limits a fund's ability to indemnify its directors. This release 
provides guidance from the staff regarding when funds may pay such 
advances.
     Section 22(g) of the Act prohibits open-end funds from 
compensating their directors with shares of the fund. This release 
provides guidance from the staff concerning the circumstances under 
which open-end funds may compensate fund directors with fund shares 
consistent with section 22(g).
    The Commission believes that publishing the staff's views on these 
issues will enhance the effectiveness of independent directors by: 
encouraging funds to nominate directors who will effectively protect 
the interests of shareholders; relieving independent directors of 
concerns regarding their ability to act in shareholders' best interests 
without undue fear of personal liability; helping funds attract the 
most qualified persons to serve on their boards; and facilitating the 
implementation of fund policies that encourage or require that fund 
directors be compensated with fund shares, thereby aligning more 
closely the interests of independent directors and fund shareholders.
    We also discuss the Commission's views regarding its role and 
response in disputes between independent directors and investment 
advisers when there are allegations of violations of the federal 
securities laws. The Commission and the staff hope thereby to dispel 
any confusion that may exist regarding the Commission's role in 
connection with disputes between independent fund directors and fund 
management.

I. Background

A. The Role and Independence of Independent Directors

    The critical role of independent directors of investment companies 
is necessitated, in part, by the unique structure of investment 
companies. Unlike a typical corporation, a fund generally has no 
employees of its own. Its officers are usually employed and compensated 
by the fund's investment adviser, which is a separately owned and 
operated entity. The fund relies on its investment adviser and other 
affiliates--who are usually the very companies that sponsored the 
fund's organization--for basic services, including investment advice, 
administration, and distribution.
    Due to this unique structure, conflicts of interest can arise 
between a fund and the fund's investment adviser because the interests 
of the fund do not always parallel the interests of the adviser. An 
investment adviser's interest in maximizing its own profits for the 
benefit of its owners may conflict with its paramount duty to act 
solely in the best interests of the fund and its shareholders.
    In an effort to control conflicts of interest between funds and 
their investment advisers, Congress required that at least 40% of a 
fund's board be composed of independent directors.\3\ Congress intended 
to place independent directors in the role of ``independent 
watchdogs,'' who would furnish an independent check upon the management 
of funds and provide a means for the representation of shareholder 
interests in fund affairs.\4\
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    \3\ Section 2(a)(19) [15 U.S.C. Sec. 80a-2(a)(19)] (defining the 
term ``interested person'') and Section 19(a) [15 U.S.C. Sec. 80a-
10(a)]. In addition, Congress required that at least a majority of 
the directors not be: (1) ``interested persons'' of the fund's 
principal underwriter, Section 10(v) [15 U.S.C. Sec. 80a-10(b)]; (2) 
investment bankers, or affiliated persons of investment bankers, 
Section 10(b)(3) [15 U.S.C. Sec. 80a-10(b)(3)]; or (3) officers, 
directors or employees of any one bank. Section 10(c) [15 U.S.C. 
Sec. 80a-10(c)].
    \4\ See Burks v. Lasker, 44 U.S. 471, 484 (1979) (quoting 
Tannenbaum v. Zeller, 552 F. 2d 402, 406 (2d Cir. 1979) and 
Investment Trusts and Investment Companies: Hearings on H.R. 10065 
Before the House Subcomm. on Interstate and Foreign Commerce, 76th 
Cong., 3d Sess. 109 (1940) (statement of David Schenker, Chief 
Counsel, Investment Trust Study, SEC) (``House Hearings'')).
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    Independent directors play a critical role in policing the 
potential conflicts of interest between a fund and its investment 
adviser. The Act requires that a majority of a fund's independent 
directors: approve the fund's contracts with its investment adviser and

[[Page 59878]]

principal underwriter;\5\ select the independent public accountant of 
the fund;\6\ and select and nominate individuals to fill independent 
director vacancies resulting from the assignment of an advisory 
contract.\7\ In addition, rules promulgated under the Act require 
independent directors to: approve distribution fees paid under rule 
12b-1 under the Act;\8\ approve and oversee affiliated securities 
transactions;\9\ set the amount of the fund's fidelity bond;\10\ and 
determine if participation in joint insurance contracts is in the best 
interest of the fund.\11\ Each of these duties and responsibilities is 
vital to the proper functioning of fund operations and, ultimately, the 
protection of fund shareholders.\12\
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    \5\ Sections 15(a) and (b) [15 U.S.C. Secs. 80a-15(a), (b)].
    \6\ Section 32(a) [15 U.S.C. Sec. 80a-31(a)].
    \7\ Sections 16(b) and 15(f)(1)(A) [15 U.S.C. Secs. 80a-16(b), 
15(f)(1)(A)].
    \8\ Rule 12b-1 [17 CFR 270.12b-1]
    \9\ Rules 10f-3, 17a-7, 17a-8, and 17e-1 [17 CFR 270.10f-3, 
270.17a-7, 270.17a-8, and 270.17e-1]
    \10\ Rule 17g-1 [17 CFR 270.17g-1]
    \11\ Rule 17d-1(d)(7) [17 CFR 270.17d-1(d)(7)].
    \12\ The full board of directors also has certain other 
responsibilities, including, but not limited to: (1) Approving the 
fund's valuation procedures, custody agreements, and brokerage 
allocation policies; (2) monitoring the fund's investments and 
investment performance and any allocation of expenses between the 
company and its affiliates; (3) authorizing the mergers of two or 
more affiliated funds and the issuance and sale of shares of the 
fund; and (3) declaring dividends in accordance with the fund's 
investment policies and objectives.
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    In addition to the requirements of federal law, directors must 
abide by standards of care prescribed by state statutory and common 
law. Specifically, directors are subject to state law duties of care 
and loyalty.\13\ The duty of care generally requires that directors act 
in good faith and with that degree of diligence, care and skill that a 
person of ordinary prudence would exercise under similar circumstances 
in a like position.\14\ The duty of loyalty generally requires that 
directors exercise their powers in the interests of the fund and not in 
the directors' own interests or in the interests of another person or 
organization.\15\
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    \13\ The business judgment rule generally protects fund 
directors from liability for their decisions so long as the 
directors acted in good faith, were reasonably informed, and 
rationally believed that the action taken was in the best interests 
of the fund. See Solomon v. Armstrong, 1999 Del. Ch. LEXIS 62, 23 
(Del. Ch. Mar. 25, 1999). See generally James Solheim, J.D. and 
Kenneth Elkins, J.D., 3A Flechter Cyc Corp Sec. 1036 (perm. ed.).
    \14\ See Hanson Trust PLC v. ML SCM Acquisition Inc., 781 F.2d 
264, 273 (2d Cir. 1986) and Norlin Corp. v. Rooney, Pace Inc., 744 
F.2d 255, 264 (2d Cir. 1984). See generally Solheim and Elkins, 
supra note 13 at Sec. 1029.
    \15\See Norlin Corp. 744 F.2d at 264 (citing Pepper v. Litton, 
308 U.S. 295, 306-07 (1939)). See generally Beth A. Buday and Gail 
A. O'Gradney, 3 Fletcher Cyc Corp Sec. 913 (Perm Ed).
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B. Improving Fund Governance

    The role of independent fund directors, and proposals to enhance 
their independence and effectiveness, have been the subject of a number 
of initiatives since the Act was enacted in 1940. For example, the 
Wharton School, at the request of the Commission, began a detailed 
study of the fund industry in the late 1950s. At that time, any person 
who was not an officer, employee or investment adviser of a fund, or an 
affiliated person of the investment adviser, could serve as an 
independent director of the fund. Under this standard, the Wharton 
study questioned the ``extent to which reliance can be placed on the 
independent directors to safeguard adequately the rights of 
shareholders in negotiations between the [fund] and the investment 
adviser.'' \16\ The Commission followed the Wharton study with its own 
study, which agreed that the then-current standard for director 
independence was inadequate.\17\ Subsequently, Congress enacted an 
amendment to the Act in 1970 which required that independent directors 
not be ``interested persons'' of a fund under new section 2(a)(19) of 
the Act.\18\ The amendment substantially limited the categories of 
persons who could serve as independent directors for funds.\19\
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    \16\ Wharton School of Finance and Commerce, A Study of Mutual 
Funds, H.R. Rep. No. 2274, 87th Cong., 2d Sess. 8 (1962).
    \17\ SEC, Public Policy Implications of Investment Company 
Growth, H.R. Rep. No. 2337, 89th Cong., 2d Sess. 333 (1966).
    \18\ See S. Rep. No. 184, 91st Cong., 1st Sess. 32-33 (1969).
    \19\ The Commission, however, has provided some flexibility by 
promulgating rules that broaden the categories of persons who can 
serve as independent directors of a fund. For example, registered 
broker-dealers and their affiliated persons are considered 
``interested persons'' of a fund, and its investment adviser or 
principal underwriter. See Sections 2(a)(19)(A) and (B)(v) [15 
U.S.C. Secs. 80a-2(a)(19)(A)(v), (B)(v)]. Under rule 2a19-1, 
however, a fund director who is an affiliated person of a registered 
broker or dealer will not be deemed to be an ``interested person'' 
of the fund, or its investment adviser or principal underwriter, 
provided that, among other things, the broker or dealer does not 
sell fund shares or effect portfolio transactions for the fund. Rule 
2a19-1 [17 CFR 270.2a19-1].
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    The Commission staff revisited the issue of the effectiveness of 
fund directors in the early 1990s, which culminated in a published 
report in 1992.\20\ The staff concluded that the governance model 
embodied in the Act was sound, but suggested a number of changes 
designed to improve the effectiveness of fund directors. One of these 
recommendations was to increase the minimum percentage of independent 
directors on fund boards from 40% to greater than 50%. In addition, the 
staff suggested that a fund's independent directors be allowed to 
choose the persons who would fill independent director vacancies and 
that the independent directors be given the express authority to 
terminate advisory contracts.
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    \20\ Division of Investment Management, SEC, Protecting 
Investors: A Half Century of Investment Company Regulation, Ch. 7 
(1992).
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    Fund governance has recently returned to the forefront. The press 
has questioned the effectiveness of independent directors \21\ and, in 
a number of instances, independent directors have come under fire by 
fund management and been replaced with directors who were nominated by 
management.\22\ Private litigants have challenged independent 
directors' independence,\23\ and the Commission has instituted 
enforcement actions against independent directors for failing to 
fulfill their legal obligations.\24\ The prominence of these 
developments has been magnified by the extraordinary growth of the fund 
industry.\25\
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    \21\ See, e.g., Russ Wiles, Third Quarter Review: Your Money, 
Investments and Personal Finance; Study Raises Questions About the 
Vigilance of the Family Watchdog, L.A. Times, Oct. 6, 1996, at D5; 
Charles Jaffe, Don't Count on Directors to Guard Your Interests, 
Kansas City Star, Mar. 9, 1999, at D19; and Edward Wyatt, Empty 
Suits in the Board Room; Under Fire, Mutual Fund Directors Seem 
Increasingly Hamstrung, N.Y. Times, June 7, 1998, at C1.
    \22\ See, e.g., Defeating Dissidents, Institutional Investor, 
Feb. z1999, at 112; and Edward Wyatt, Investing: Funds Watch; SEC 
Explores Directors' Roles, N.Y. Times, Jan. 31, 1999, at C9.
    \23\ See, e.g., Strougo v. Scudder, Stevens & Clark, Inc., 964 
F.Supp. 783 (S.D.N.Y. 1997); Strougo v. Bassini, et al., 97 Civ. 
3579 (S.D.N.Y. 1998); Strougo v. BEA Associates., 98 Civ. 3725 
(S.D.N.Y. 1999); and Verkouteren v. Blackrock Financial Management, 
Inc., 98 Civ. 4673 (S.D.N.Y. 1999).
    \24\ See, e.g., In the Matter of Parnassus Investments, et al., 
Initial Decision Release No. 131 (Sept. 3, 1998);  In the Matter of 
the Rockies Fund, Inc., et al., Investment Company Act Release No. 
23229 (June 1, 1998) (pending); and In the Matter of Monetta 
Financial Services, Inc., et al., Investment Company Act Release No. 
23048 (May 8, 1998) (pending).
    \25\ See Investment Company Institute, Mutual Fund Fact Book 3 
(1999). Total assets of open-end funds were $5.525 trillion at the 
end of 1998, compared with $809.4 billion in 1988. In 1998, an 
estimated 44 percent of U.S. households owned open-end funds, up 
from 5.7 percent in 1980 and 24.4 percent in 1988. Id. at 45.
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    In recognition of the increasingly important role that funds play 
in Americans' finances, and that independent directors play in 
protecting fund investors, the Commission launched an initiative to 
explore the state of fund governance and to determine what improvements 
could be made. Last February, the Commission hosted a Roundtable on the 
Role of Independent Investment Company Directors to discuss the role of

[[Page 59879]]

independent directors and the steps that could be taken to improve 
their effectiveness. There was broad agreement among Roundtable 
participants that fund governance could be improved to enable 
independent directors to better serve fund shareholders.\26\
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    \26\ See SEC, Roundtable on the Role of Independent Investment 
Company Directors, Feb. 23-24, 1999 (``Roundtable Transcript''). The 
Roundtable Transcripts are available to the public in the 
Commission's public reference room, the Commission's Louis Loss 
Library, and on the Commission's Web site at www.sec.gov/offices/
invmgmt/roundtab.htm. See also Companion Release, supra note 2, nn. 
41, 63 and 76 (citing statements of Roundtable participants).
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    Following the Roundtable, the Commission undertook a rulemaking 
initiative to implement some of the suggestions made at the Roundtable 
on how to improve fund governance.\27\ In the Companion Release, the 
Commission is proposing amendments to a number of exemptive rules under 
the Act, and is proposing to amend a number of forms to provide fund 
shareholders with improved information with which to judge the 
independence of their funds' directors. This release provides staff 
interpretive guidance regarding certain issues relating to the 
independence and role of independent fund directors, and briefly 
describes the role of the Commission in connection with disputes 
between independent fund directors and fund management.
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    \27\ At the Roundtable, Commission Chairman Arthur Levitt also 
asked the fund industry to assume an active role in establishing and 
promoting best fund governance practices. In June 1999, the 
Investment Company Institute issued a Report of the Advisory Group 
on Best Practices for Fund Directors (``ICI Advisory Group 
Report'').
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II. Interpretive Guidance

A. Commission Orders Under Section 2(a)(19) of the Act

    Sections 2(a)(19)(A)(vi) and (B)(vi) of the Act authorize the 
Commission to issue an order finding that a person is ``interested'' by 
reason of a material business or professional relationship with certain 
persons and entities.\28\ The Commission and the staff have not 
publicly provided guidance concerning these sections for a significant 
period of time.\29\ The staff believes that it would be useful to 
provide additional guidance about the types of professional and 
business relationships that may be considered to be material for 
purposes of sections 2(a)(19)(A)(vi) and (B)(vi).\30\ This guidance 
should be particularly useful because the staff understands that many 
fund groups will not nominate an individual as an independent director 
if they identify a material business or professional relationship that 
the individual has with a Specified Entity (as defined below) due to 
concerns that the Commission may commence proceedings under section 
2(a)(19).\31\
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    \28\ Section 2(a)(19)(A)(vi) of the Act defines ``interested 
person,'' when used with respect to an investment company, in part, 
as: ``any natural person whom the Commission by order shall have 
determined to be an interested person by reason of having had, at 
any time since the beginning of the last two completed fiscal years 
of such company, a material business or professional relationship 
with such company or with the principal executive officer of such 
company or with any other investment company having the same 
investment adviser or principal underwriter or with the principal 
executive officer of such other investment company.'' 15 U.S.C. 
Sec. 80a-2(a)(19)(A)(vi).
    Section 2(a)(19)(B)(vi) of the Act defines ``interested 
person,'' when used with respect to an investment adviser of or 
principal underwriter for, any investment company, in part, as: 
``any natural person whom the Commission by order shall have 
determined to be an interested person by reason of having had at any 
time since the beginning of the last two completed fiscal years of 
such investment company a material business or professional 
relationship with such investment adviser or principal underwriter 
or with the principal executive officer or any controlling person of 
such investment adviser or principal underwriter.''
    15 U.S.C. Sec. 80a-2(a)(19)(B)(vi).
    \29\ For a number of years, the staff provided some informal 
guidance by issuing no-action letters, but has not done so since 
1984 as a matter of policy. See Daniel Calabria, SEC No-Action 
Letter (Sept. 12, 1984); Capital Supervisors Helios Fund, Inc., SEC 
No-Action Letter (June 13, 1984).
    \30\ In the Companion Release, the Commission has proposed rules 
that would require additional disclosure about fund directors to, 
among other things, assist the Commission and its staff in 
evaluating directors' independence. Companion Release, supra note 2.
    \31\ See ICI Advisory Group Report, supra note 27, at 6; 
Roundtable Transcript of Feb. 24, 1999, at 253 (statement by Thomas 
R. Smith, Jr.). The staff believes that the guidance provided in 
this portion of the release may assist funds in the independent 
director nominating process.
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    The Commission has the authority to issue an order under section 
2(a)(19) of the Act when it finds that a person has or had a ``material 
business or professional relationship'' with certain specified persons 
and entities, including some fund affiliates (``Specified 
Entities'').\32\ Section 2(a)(19) does not define a ``material business 
or professional relationship.'' The legislative history, however, 
indicates that a business or professional relationship would be 
material if it ``might tend to impair the independence of [a] 
director.'' \33\ The legislative history also states that 
``[o]rdinarily, a business or professional relationship would not be 
deemed to impair independence where the benefits flow from the director 
of an investment company to the other party to the relationship. In 
such instances the relationship is not likely to make the director 
beholden to that party.'' \34\
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    \32\ Those entities include the fund, its principal executive 
officer, the investment adviser and principal underwriter of the 
fund, the principal executive officer of the investment adviser or 
principal underwriter, or any controlling person of the investment 
adviser or principal underwriter, any other fund with the same 
investment adviser or principal underwriter, and the principal 
executive officer of such other fund. See Sections 2(a)(19)(A)(iv) 
and (B)(vi) [15 U.S.C. Secs. 80a-2(a)(19)(A)(vi), (B)(vi)].
    \32\ H.R. Rep. No. 1382, 91st Cong., 2d Sess. 14 (1970); S. Rep. 
No. 184, 91st Cong., 1st Sess. 33 (1969).
    \34\ Id.
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    The staff believes that issues arising under sections 
2(a)(19)(A)(vi) and (B)(vi) must be analyzed based on the particular 
facts of each case to determine whether a director's interests and 
relationships might tend to impair his or her independence.\35\ The 
staff also believes, however, that it would be useful to provide 
guidance about the types of professional and business relationships 
between a director and a Specified Entity that may be considered to be 
material. In particular, this section of the release describes how the 
staff will analyze whether a person should be treated as ``interested'' 
by virtue of (1) holding or having held certain positions with a 
Specified Entity, and (2) engaging or having engaged in certain 
material transactions with a Specified Entity.\36\
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    \35\ The legislative history indicates that Congress intended 
for the Commission to determine whether a material business and 
professional relationship exists on a case-by-case basis. H.R. Rep. 
No. 1382, 91st Cong. 2d Sess. 15 (1970); S. Rep. No. 184, 91st 
Cong., 1st Sess. 33 (1969).
    \36\ The examples discussed in this release are not exhaustive 
and are provided for illustrative purposes only. There may be other 
relationships that would be viewed by the staff as material under 
section 2(a)(19).
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Positions as Material Business or Professional Relationships
    The staff believes that a fund director may be treated as 
``interested'' if he or she currently holds or held, at any time since 
the beginning of the last two completed fiscal years of the fund (the 
``two-year period''), certain positions with a Specified Entity. The 
staff would consider a position that a director holds with a Specified 
Entity as a ``material business or professional relationship'' if it 
would tend to impair a director's independence by providing incentives 
for the director to place his or her own interests over the interests 
of fund shareholders. The key factors in evaluating whether a 
director's position with a Specified Entity would tend to impair his or 
her independence include the level of the director's responsibility in 
the position and the level of compensation or other benefits that the 
director receives or received from the position.
    For instance, the staff would consider an individual who served as 
the fund's portfolio manager during the two-year

[[Page 59880]]

period to have had a material business or professional relationship 
with the fund and its investment adviser. The staff previously has 
informally advised certain funds of this position on several occasions. 
The staff believes that a fund's former portfolio manager must be 
viewed as having had a material business or professional relationship 
with the fund and its adviser because he or she would have had 
significant responsibilities with the fund and the adviser, and likely 
would have received substantial compensation and other benefits from 
the adviser and/or the fund.\37\ Indeed, the staff would view the 
former portfolio manager's position as material due to the manager's 
responsibility in the position even if the manager had not received 
substantial compensation from adviser or the fund. Similarly, the staff 
believes that former directors, officers, and employees of the fund's 
investment adviser or principal underwriter could be viewed as having 
had a material business or professional relationship with a Specified 
Entity, depending on the facts and circumstances.\38\
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    \37\ Similarly, the ICI Advisory Group recommends that former 
employees of a fund's investment adviser who had significant 
responsibilities in their positions with the adviser not serve as 
independent directors of the fund. See ICI Advisory Group Report, 
supra note 27, at 13.
    \38\ In addition, the staff notes that many former officers and 
employees of a fund's investment adviser or principal underwriter 
may own securities issued by the adviser or underwriter. Such 
persons are interested persons of the fund by virtue of sections 
2(a)(19)(A)(iii) and (B)(iii) [15 U.S.C. Secs. 80a-2(a)(19)(A)(iii), 
(B)(iii)].
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    In addition, a fund director who at any time during the two-year 
period also was a director, officer or employee of a current or former 
holding company of the fund's investment adviser may be treated as 
interested by reason of a material business or professional 
relationship with the controlling person of the fund's adviser (a 
Specified Entity).\39\ As described above, the staff's analysis of the 
materiality of the relationship would focus on, among other things, the 
level of the director's responsibility with the holding company and the 
level of compensation or other benefits that the director received from 
the position.
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    \39\ See also Western Separate Account A, SEC No-Action Letter 
(Mar. 8, 1976) (directors who are employees or executives of a fund 
adviser, principal underwriter or controlling person may not be 
disinterested); NEA Mutual Fund, SEC No-Action Letter (June 3, 1971) 
(directors who are employees or executives of an entity that 
controls the fund's adviser or principal underwriter may not be 
disinterested).
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    The staff believes that not every position that a director holds or 
held with a Specified Entity would be deemed to impair his or her 
independence. For example, a director of a fund who also is a director 
of another fund managed by the same adviser generally would not be 
viewed as an interested person of the fund under section 2(a)(19) 
solely as a result of this relationship.\40\
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    \40\ See H.R. Rep. No. 1382, 91st Cong., 2d Sess. 15 (1970); S. 
Rep. No. 184, 91st Cong., 1st Sess. 34 (1969) (stating that ``a 
director of one investment company would not ordinarily be deemed an 
interested person of that company by reason of being a director of 
another investment company with the same adviser'').
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Material Transactions as Material Business or Professional 
Relationships
    The staff believes that a fund director may be treated as 
``interested'' if he or she has, at any time during the two-year 
period, directly or indirectly engaged (or proposed to engage) in any 
material transactions (or proposed material transactions) with a 
Specified Entity. Such a relationship could result from a single 
transaction or from multiple transactions. These transactions may be 
structured as service arrangements, including legal, investment 
banking, and consulting services, or other business transactions, such 
as business and personal loans, and real estate purchases.\41\ In 
addition, a material business or professional relationship with a 
Specified Entity may result from a fund director's position with, or 
ownership interest in, an entity that engages in material transactions 
with a Specified Entity.
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    \41\ See, e.g., Alpha Investors Fund, SEC No-Action Letter (Jan. 
9, 1972) (director who is a partner at a law firm that provides 
legal services to an entity that controls the fund's adviser may be 
interested under section 2(a)(19)(B)(vi) because the director has a 
material business or professional relationship with that entity).
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    For example, the staff believes that a fund director may be treated 
as ``interested'' if the fund's investment adviser manages or managed 
for the director, at any time during the two-year period, an advisory 
or brokerage account, and the adviser favors, or creates the 
expectation that it will favor, the account over the other accounts 
that it manages.\42\ In the staff's view, a director would receive 
favored treatment, for instance, if the adviser charged the director no 
fees or fees that were lower than the fees that it charged for similar 
types of accounts, or accorded the director's account special treatment 
regarding portfolio management decisions or securities allocations. By 
favoring the director's account over other accounts that it manages, 
the adviser may create an incentive for the director to act in a manner 
that will preserve or increase the favorable treatment.\43\ In this 
instance, significant economic benefits from the relationship between 
the director and the adviser would flow to the director, or the 
director may have the expectation that significant economic benefits 
would flow in the future to the director.\44\
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    \42\ Cf. H.R. Rep. No. 1382, 91st Cong., 2d Sess. 15 (1970); S. 
Rep. No. 184, 91st Cong., 1st Sess. 34 (1969) (stating that ``a 
director ordinarily would not be considered to have a material 
business relationship with the investment adviser simply because he 
is a brokerage customer who is not accorded special treatment'').
    \43\ Such favoritism would raise additional issues under the 
federal securities laws. See, e.g., In the Matter of Monetta 
Financial Services, Inc., supra note 24.
    \44\ For an example of a relationship in which the staff 
believed that significant economic benefits did not flow to the 
director, see Securities Groups, SEC No-Action Letter (Apr. 20, 
1981) (staff stated that a nominated director's participation in a 
symposium sponsored by the parent of the fund's adviser did not 
constitute a material relationship because ``the $2,000 paid to him 
for taking part in that seminar is not so significant as to tend to 
impair his independence were he to serve as a disinterested director 
of the fund'').
---------------------------------------------------------------------------

    The staff believes that a fund director who serves as a chief 
executive officer of any company for which the chief executive officer 
of the fund's adviser serves as a director also may be treated as 
``interested.'' The relationship between the fund director and the 
adviser's chief executive officer may tend to impair the director's 
independence because the adviser's chief executive officer has the 
power to vote on matters that affect the director's compensation and 
status as chief executive officer of the company. In this instance, the 
fund director may act with respect to fund matters in a manner to 
preserve his or her relationship with the company and with the 
adviser's chief executive officer, rather than in the interest of the 
fund's shareholders.\45\
---------------------------------------------------------------------------

    \45\ See Southwestern Investors, Inc., SEC No-Action Letter 
(June 13, 1971) (fund director who is an officer and director of 
company A may not be disinterested if the president of a company 
that indirectly controls the fund's investment adviser and principal 
underwriter also serves as a director of company A). Cf. H.R. Rep. 
No. 1382, 91st Cong., 2d Sess. 15 (1970); S. Rep. No. 184, 91st 
Cong., 1st Sess. 34 (1969) (fund director that serves with the chief 
executive officer of the fund's adviser on the board of another 
company generally would not be deemed to have a material business or 
professional relationship with the chief executive officer). Unlike 
the facts in Southwestern Investors, Inc., the fund director 
described in the House and Senate Reports was not an officer or 
employee of the other company, such that the chief executive officer 
of the fund's adviser did not appear to have the power to vote on 
matters affecting the fund director's status with the other company.
---------------------------------------------------------------------------

    A fund director may be deemed to have indirectly engaged in a 
material transaction with a Specified Entity through his or her 
interest in a company that conducted business with the Specified 
Entity.\46\ In determining

[[Page 59881]]

whether the director would have a material business or professional 
relationship with a Specified Entity due to his or her interest in the 
company and the company's transaction with the Specified Entity, the 
staff would look to the nature and significance of the director's 
interest in the company and the company's interest in the transaction. 
In particular, the staff would focus on the significance of any 
economic or other benefit that would flow to the director. For example, 
a fund director who had a controlling interest in a company that 
conducted material business with a fund would likely receive 
significant economic benefits, either directly or indirectly, as a 
result.\47\ Such a director may be treated as interested because the 
director may have a material business or professional relationship with 
the fund as a result of having indirectly engaged in a material 
transaction with the fund.
---------------------------------------------------------------------------

    \46\ See also The MONY Fund, Inc., SEC No-Action Letter (Jan. 
29, 1972) (director who is a senior officer of a company that 
contracted with company A, which wholly owns the fund's investment 
adviser, to find a vice president for company A, may have a material 
relationship with a controlling person of the fund's adviser).
    \47\ Cf. Travelers Equities Fund, Inc., SEC No-Action Letter 
(Jan. 11, 1982) (director who is a limited partner of a partnership 
that obtained a loan from the principal underwriter of the fund is 
not an interested person of the underwriter).
---------------------------------------------------------------------------

    A material relationship resulting from a proposed material 
transaction with a Specified Entity might include the negotiation of a 
service contract between a company controlled by the director and the 
Specified Entity. During the negotiation of such a contract (and even 
if such contract is never finalized), the director may be concerned 
about interests other than those of the fund and its shareholders. As a 
result, the process of negotiating a material transaction may tend to 
impair the director's independence, and thus may itself create a 
material business or professional relationship with a Specified Entity 
for purposes of section 2(a)(19).
Other Related Matters
    In the Companion Release, the Commission is proposing amendments to 
various disclosure requirements. The purpose of the proposed disclosure 
amendments is, in part, to assist the Commission and the staff in 
determining whether it would be appropriate to make further inquiry 
into a particular director's independence. If the proposed rules are 
adopted, the staff will review and monitor the new disclosure. Based on 
its review of the disclosure, the staff will consider whether to issue 
additional guidance regarding other types of relationships that may be 
considered to be material under section 2(a)(19).

B. Independent Directors and Section 17(d) and Rule 17d-1

    In the course of their duties, fund directors often take actions on 
behalf of a fund that may also benefit themselves in some way. Some 
have questioned whether these actions may run afoul of certain 
provisions of the Act that prohibit affiliated transactions. As 
discussed in greater detail below, the staff generally believes that 
they do not, and believes that it would be beneficial to fund directors 
for the staff to clarify its views on these matters.
    As discussed previously, a fund's board of directors is charged 
with the responsibility of protecting the interests of fund 
shareholders by overseeing the operations of the fund and policing 
conflicts of interests. Fund directors must fulfill this 
responsibility, regardless of whether they may personally benefit from 
their actions, or whether their actions are contrary to the wishes of 
fund management. Some have argued that actions taken by directors on 
behalf of a fund that also provide some benefit to the directors could 
constitute a joint transaction for purposes of section 17(d) \48\ of 
the Act and rule 17d-1 \49\ thereunder.\50\
---------------------------------------------------------------------------

    \48\ Section 17(d) [15 U.S.C. Sec. 80a-17(d)].
    \49\ Rule 17d-1 [17 CFR 270.17d-1].
    \50\ See Verified Complaint, In the Matter of Yacktman v. 
Carlson, No. 98278117 (Cir. Ct. Md. 1998).
---------------------------------------------------------------------------

    Section 17(d) and rule 17d-1 generally prohibit an affiliated 
person of an investment company (which includes a fund director) or an 
affiliated person of such person (``affiliate''), acting as principal, 
from participating in or effecting any transaction in connection with 
any joint enterprise or other joint arrangement or profit-sharing plan 
in which the investment company is also a participant, unless an 
application regarding the joint arrangement has been filed with and an 
order authorizing the transaction has been granted by the Commission. A 
joint enterprise or other joint arrangement or profit-sharing plan 
(``joint arrangement'') is broadly defined in rule 17d-1(c) to include 
any written or oral plan, contract, authorization or arrangement, or 
any practice or understanding concerning an enterprise or undertaking 
whereby the investment company and the affiliate have a joint or a 
joint and several participation, or share in the profits of such 
enterprise or undertaking.
    Fund directors commonly authorize the use of fund assets to make 
payments from which the directors may personally benefit, such as 
director salaries, board meeting expenses, proxy expenses, and legal 
fees of counsel to the independent directors. As a practical matter, 
the staff believes that interpreting rule 17d-1 as encompassing such 
actions could impede, or in some cases prevent, fund directors from 
taking actions that would be in the best interests of shareholders. 
Such a broad reading also could be used to prevent fund directors from 
fulfilling their responsibilities, such as opposing a proxy 
solicitation that they believe is not in the best interests of fund 
shareholders, or otherwise acting to protect shareholder interests.\51\ 
Furthermore, the staff believes that requiring a fund to obtain a 
Commission order for every action that results in some benefit to 
directors would be unduly burdensome and could impede the efficient 
operation of funds.
---------------------------------------------------------------------------

    \51\ This prospect was raised in connection with recent 
litigation arising out of a dispute between the independent 
directors of a fund and its investment adviser. In the course of the 
dispute, the president of the fund, who also was the president of 
the investment adviser, called a special shareholders meeting and 
initiated a proxy contest to replace the independent directors. In 
addition, the investment adviser filed a lawsuit seeking to enjoin 
the fund's independent directors from using the fund's assets to pay 
for the fund's proxy expenses on the theory that such payment would 
be a joint arrangement among the fund and the independent directors 
in violation of section 17(d) and rule 17d-1. In response, the staff 
issued a letter to the parties indicating that it seriously 
questioned whether payment of the proxy expenses out of fund assets 
required a prior order under section 17(d) and rule 17d-1. See 
Letter from Jacob H. Stillman and Douglas Scheidt to Richard Teigen, 
Esq., et. al, October 16, 1998. This letter is included in the 
public comment file for the Companion Release. See supra note 2, at 
S7-23-99.
---------------------------------------------------------------------------

    The staff believes that it would be helpful to fund directors to 
clarify the meaning of ``joint arrangement'' in the context of actions 
taken in their capacities as directors. As a general matter, the staff 
believes that the actions of fund directors taken in their capacities 
as directors would not constitute joint arrangements for purposes of 
rule 17d-1. Joint arrangements require ``some element of combination'' 
between the fund and its affiliate.\52\ The staff believes that, when a 
fund's directors are acting on behalf of the fund in their capacities 
as fund directors, the requisite element of ``combination'' is not 
present. Indeed, in order for the requisite element of ``combination'' 
to be present, the staff generally believes that the joint arrangement 
must involve activities that

[[Page 59882]]

are beyond the scope of the directors' duties to the fund.\53\
---------------------------------------------------------------------------

    \52\ SEC v. Tally Industries, Inc., 399 F.2d 396, 403 (2d Cir. 
1968), cert. denied, 393 U.S. 1015 (1969); and Deferred Compensation 
Plans for Investment Company Directors, SEC No-Action Letter (May 
14, 1998).
    \53\ For example, the staff believes that a joint transaction 
would not exist if fund directors authorized the use of fund assets 
to pay for proxy expenses incurred in connection with the directors' 
uncontested re-election, notwithstanding that they could benefit 
personally from such expenditures. Similarly, the staff believes 
that, if a third party such as the fund's investment adviser 
initiated a proxy contest to unseat the fund's independent 
directors, the directors' use of fund assets to solicit proxies in 
favor of their re-election would not constitute a joint transaction. 
Accord Order Granting Defendants' Emergency Motion to Modify 
Temporary Restraining Order, Yacktman v. Carlson, Case No. AMD 98-
3496 (D. Md. 1998) (vacating temporary restraining order enjoining 
directors from using fund assets to pay proxy expenses).
---------------------------------------------------------------------------

    In the staff's view, the fact that fund expenditures may benefit 
the directors in some way is not sufficient to render them ``joint 
arrangements'' among the fund and the directors for purposes of rule 
17d-1. Whether there is ``some element of combination'' does not depend 
on whether the directors' actions were motivated by self-interest. If, 
in fact, the directors were motivated solely by self-interest, they may 
have breached their duties of care or loyalty under state law or 
breached their fiduciary duties under section 36(a) of the Act.\54\ But 
whether rule 17d-1 applies turns on the nature of the transaction, not 
on its propriety or the affiliate's motives, provided that the 
directors are acting within the scope of their duties. The staff 
believes that fund directors must be able to fulfill their duties 
without fear that their actions, even those from which they may 
personally benefit, may result in a joint transaction for purposes of 
rule 17d-1.
---------------------------------------------------------------------------

    \54\ Section 36(a) [15 U.S.C. 80a-35(a)]. Section 36(a) 
authorizes the Commission to institute a lawsuit alleging, among 
other things, that an officer or director of a fund, including an 
independent director, has engaged in an ``act or practice 
constituting a breach of fiduciary duty involving personal 
misconduct in respect of any [fund] for which such person so serves 
or acts.'' The Commission has used its authority under section 36(a) 
in a number of cases, including cases in which the Commission called 
into question the conduct of a fund's independent directors. See, 
e.g., SEC v. Treasury First, Inc., Litigation Release No. 13094 
(Nov. 19, 1991); SEC v. Forty Four Management, Ltd., Litigation 
Release No. 11717 (Apr. 28, 1988); and SEC v. American Birthright 
Trust Management Company, Inc., Litigation Release No. 9266 (Dec. 
30, 1980).
    In addition, section 37 of the Act prohibits persons from 
unlawfully and willfully converting to their own use or the use of 
another person any funds or assets of a registered investment 
company. See, e.g., SEC v. Donna Tumminia, Litigation Release No. 
14217 (Sept. 1, 1994); and SEC v. Lazzell, Litigation Release No. 
12585 (Aug. 17, 1990).
---------------------------------------------------------------------------

C. Advances of Legal Expenses to Independent Directors

    As a consequence of their ``watchdog'' role in policing potential 
conflicts of interests, fund directors have heightened exposure to 
personal liability for actions that they take which they believe to be 
in the best interests of the fund and its shareholders.\55\ The risk of 
personal liability could, however, deter some independent directors 
from making controversial decisions that may benefit the fund and 
discourage qualified individuals from serving as independent directors. 
The staff has sought to address these concerns by interpreting the Act 
to permit funds to advance legal fees to their directors under certain 
circumstances. Nonetheless, participants at the Commission's Roundtable 
on the Role of Independent Investment Company Directors (and others) 
have advised the staff that additional guidance may be necessary to 
clarify some uncertainties that may exist about certain aspects of the 
staff's positions. These uncertainties could make it unnecessarily 
difficult for some independent directors to receive advances of legal 
fees, particularly during disputes with the fund's investment adviser. 
The staff therefore is providing the following guidance regarding when 
funds may advance legal fees to their independent directors.
---------------------------------------------------------------------------

    \55\ The Act places substantial responsibilities on the 
independent directors of investment companies to protect the 
interests of fund shareholders by policing potential conflicts of 
interest. These responsibilities are in addition to the general 
duties of loyalty and care imposed on directors under state law. The 
Act and state law also provide fund shareholders with private rights 
of action against directors who fail to exercise reasonable care in 
the fulfillment of their duties. See, e.g., Strougo v. Scudder, 
Stevens & Clark, Inc., supra note 23, at 796-798 (holding that fund 
shareholder has a private right of action under section 36(a) 
against, among others, the independent directors of the fund). See 
also Pui-Wing Tam, ``Jury Gives Boost to Independent Directors,'' 
Wall St. J. at C19 (July 26, 1999) (trial of action by certain 
shareholders of a fund and the fund's investment adviser against 
former independent fund directors for breach of fiduciary duty 
resulted in jury verdict for defendants); Richard A. Oppel Jr., A 
Potentially Costly Lawsuit, N.Y. Times at sec. 3, at 7 (Aug. 1, 
1999) (former independent fund directors sued by investment adviser 
and fund shareholders, see supra, may seek recovery of millions of 
dollars in legal fees from fund that has assets of only $37.5 
million).
---------------------------------------------------------------------------

    The defense of a lawsuit against a fund director can severely 
deplete the director's personal assets. If a director is found liable, 
even for mere negligence, the potential financial burdens may far 
exceed the director's ability to pay, and be greatly disproportionate 
to the financial and other benefits of serving as a director. Even if 
the lawsuit is without legal merit, the costs of defending it can be 
high. Without some protection against the risks of incurring these 
costs, directors may avoid making controversial decisions, even if 
those decisions would have been in the best interests of the fund and 
its shareholders. Indeed, the potential liability attendant upon 
service as a director of a fund can have the effect of discouraging 
qualified individuals from serving in that capacity.
    One commonly used approach to address this problem is for funds to 
agree to indemnify directors for personal financial liability arising 
out of actions taken in their capacities as directors.\56\ Any 
indemnification provisions, however, are subject to section 17(h) of 
the Act. Section 17(h) generally prohibits a fund from including in its 
organizational documents any provision that protects a director or 
officer of a fund against any liability to the fund or its shareholders 
by reason of willful misfeasance, bad faith, gross negligence or 
reckless disregard of his or her duties as director or officer 
(collectively, ``disabling conduct'').\57\ Section 17(h) is intended to 
balance the need to ensure that funds have the ability to indemnify 
directors for liability arising out of actions that they took in good 
faith with the need for funds and their shareholders to be able to hold 
fund directors personally accountable for their actions as 
directors.\58\
---------------------------------------------------------------------------

    \56\ American Bar Association, Section of Business Law, Fund 
Director's Guidebook 70 (1996). Funds also commonly obtain ``errors 
and omissions'' insurance policies to cover expenses incurred by 
directors and officers in the event of litigation. These policies 
often are joint policies that cover numerous funds within a fund 
family as well as the funds' investment adviser and principal 
underwriter, and have generally excluded claims in which one party 
covered by the policy sues another. Although section 17(d) of the 
Act and rule 17d-1 thereunder generally prohibit such jointly 
arrangements, see supra text accompanying notes 48-51, rule 17d-
1(d)(7) permits the purchase of joint errors and omission policies. 
The Commission is proposing to amend rule 17d-1(d)(7) [17 CFR 
270.17d-1(d)(7)] to make the rule available only for joint insurance 
policies that do not exclude coverage for litigation between a 
fund's independent directors and investment adviser. See Companion 
Release, supra note 2, at Section II.B.
    \57\ See Section 17(h) [15 U.S.C. Sec. 80a-17(h)]. State laws 
similarly limit the ability of investment companies to indemnify 
their directors and officers. At least one commenter has suggested 
that such state law provisions that are more restrictive than 
section 17(h) probably are not susceptible to challenge on the 
grounds of federal preemption. See Newman, O'Dell and Kenyon, 
Indemnification and Insurance, ALI-ABA Course of Study: Investment 
Company Regulation and Compliance 217,220 (June 11, 1998).
    \58\ See Chabot v. Empire Trust Co., 301 F.2d 458,460 (2d Cir. 
1962) (``The purpose of [section] 17(h) is to ensure that liability 
for violation of the duties and standards provided by the Act will 
not be defeated by the inclusion of protective contractual 
clauses'').
---------------------------------------------------------------------------

    The staff has taken the position that the prohibitions of section 
17(h) apply to advances for legal fees, as well as to payments for 
settlements and judgments.\59\ The staff believes that

[[Page 59883]]

section 17(h) is intended to ensure that directors can be held 
personally accountable for any costs that may result from their 
disabling conduct, including those costs, such as legal fees, that are 
indirect results of litigation or the threat thereof.
---------------------------------------------------------------------------

    \59\ ``Indemnification by Investment Companies,'' Investment 
Company Act Release No. 11330 (Sept. 4, 1980) (``Release 11330'') 
[20 SEC Docket 1342]. As noted in Release 11330, improper advances 
or payments for settlements or judgments could form the basis of an 
action under sections 36(a) and 37 of the Act. See supra note 54.
---------------------------------------------------------------------------

    The staff also has taken the position that, before advancing legal 
fees to a director, a fund's board must either (1) obtain assurances, 
such as by obtaining insurance or receiving collateral provided by the 
director, that the advance will be repaid if the director is found to 
have engaged in disabling conduct, or (2) have a reasonable belief that 
the director has not engaged in disabling conduct and ultimately will 
be entitled to indemnification.\60\ The staff has stated that a 
reasonable belief may be formed either by a majority of a quorum of the 
independent, non-party directors of the investment company, or based on 
a written opinion \61\ provided by independent legal counsel that in 
turn is based on counsel's review of the readily available facts (as 
opposed to a full trial-type inquiry).\62\ These positions are intended 
to permit a fund to protect its directors against the legal costs 
attendant upon defending and resolving lawsuits, while preventing or 
minimizing the risk that a fund's assets will be used to indemnify 
directors for legal fees that are incurred as a result of the 
directors' disabling conduct.
---------------------------------------------------------------------------

    \60\ Before Release 11330 was issued, the staff has taken the 
position that a fund could not advance legal fees unless it had 
obtained insurance or received sufficient collateral. It response to 
complaints that this requirement was unduly burdensome and 
expensive, the staff revised its position to permit a fund also to 
advance legal fees on the basis of a reasonable belief that the 
director had not engaged in disabling conduct and ultimately would 
be entitled to indemnification. See id.
    \61\ The opinion must set forth the facts and legal analysis 
that formed the basis for counsel's conclusion. See Steadman 
Security Corp., SEC No-Action Letter (Apr. 18, 1983) (concluding, 
among other things, that neither the board's resolutions, nor the 
legal opinion submitted to the board, contained any facts or legal 
analysis supporting indemnification). Similarly, any finding made by 
the disinterested, non-party directors should be memorialized in a 
written document that also contains the information upon which the 
directors relied to reach their decision. Id.
    \62\ The staff also believes that non-party independent 
directors or independent legal counsel must make a reasonable belief 
determination prior to each advance of legal fees to fund directors. 
See infra note 65. Such a determination should include the 
consideration of any new information that is readily available.
---------------------------------------------------------------------------

    The staff has been advised that these positions may make it 
unnecessarily difficult for funds to advance legal fees to their 
directors. This could inhibit the willingness of independent directors 
to take appropriate but controversial actions and discourage qualified 
individuals from serving as independent directors. This problem may be 
particularly acute when there is a dispute between the fund's 
investment adviser and the fund's independent directors, as the 
investment adviser in some circumstances would be able to influence any 
determination about the whether the directors had engaged in disabling 
conduct. For example, persons who had been ousted as independent 
directors in a proxy battle with management might question the ability 
or willingness of the fund's new independent directors to objectively 
determine whether there was reason to believe that the ousted directors 
had engaged in disabling conduct because the directors may have been 
nominated by the fund's investment adviser.
    The staff has recently addressed the issue of whether independent 
directors should be afforded a presumption that they have not engaged 
in disabling conduct within the meaning of section 17(h). Independent 
directors are presumed by the nature of their qualifications to be free 
of many of the kinds of conflicts that may color their judgment and 
affect their actions as directors.\63\ On this basis, the staff 
reasoned that it would be consistent with section 17(h) and prior staff 
positions if legal counsel--in providing an opinion as to whether a 
fund should advance legal fees either to its independent directors or 
to any directors who are interested persons solely by reason of serving 
as officers of the fund--afforded the directors a rebuttable 
presumption that they had not engaged in disabling conduct.\64\ The 
staff stated that this position was limited to actions taken by 
directors while acting in their capacities as directors. The staff 
believes that the rebuttable presumption also should apply in 
situations when the independent, non-party directors of the investment 
company, rather than independent legal counsel, make the reasonable 
belief determination.
---------------------------------------------------------------------------

    \63\ For example, affiliated persons of the fund's investment 
adviser cannot serve as a independent directors. See Section 
2(a)(19) [15 U.S.C. 080a-2(a)(19)].
    \64\ The Yacktman Funds, Inc., SEC No-Action Letter (Dec. 18, 
1998).
---------------------------------------------------------------------------

    Another related issue is the degree of due diligence that would be 
necessary for independent, non-party directors or independent legal 
counsel to make a reasonable belief determination. As noted above, the 
staff has stated that the directors or counsel could rely on a review 
of the readily available facts, and that a full trial-type inquiry was 
unnecessary. Thus, we would not expect the directors or counsel to 
engage in fact-finding to the same degree as one might undertake to 
prepare for a trial, which might include taking depositions, issuing 
interrogatories, or interviewing every witness involved in the dispute. 
Furthermore, while the level of review that would be required to be 
undertaken by the directors or counsel would depend on the particular 
facts and circumstances of each situation, the review need only be 
sufficient to form the basis of a reasonable, but not necessarily 
conclusive, belief.
    The staff believes, however, that the directors and counsel should 
give certain information significant weight when making a reasonable 
belief determination. For example, the staff believes that the 
directors and counsel would be precluded, in most cases, from making a 
reasonable belief determination once a court or other body before which 
the relevant proceeding was brought found that a director had engaged 
in disabling conduct, notwithstanding the possibility that the director 
might prevail on appeal.\65\ When directors and counsel cannot make a 
reasonable belief determination, the staff believes that section 17(h) 
would prohibit the fund from advancing legal fees to the director 
unless the fund obtained assurances that the advance will be repaid if 
the director ultimately is found to have engaged in disabling conduct. 
Conversely, the dismissal of a court action or an administrative 
proceeding against a director for insufficiency of evidence of any 
disabling conduct would likely provide the basis for a reasonable 
belief that the director had not engaged in such conduct.\66\
---------------------------------------------------------------------------

    \65\ The staff also has previously stated that directors should 
consider whether advances of legal expenses may involve a breach of 
fiduciary duty involving personal misconduct under section 36(a) of 
the Act or misuse of fund assets in violation of section 37 of the 
Act. Sections 36(a) and 37 [15 U.S.C. Secs. 80a-35(a), 80a-36]. Id. 
and supra note 54. When authorizing the fund to make an advance of 
legal expenses, fund directors should consider whether the amount of 
the advance is reasonable at that point in the litigation. For 
example, it generally may be inappropriate for the fund directors to 
authorize the fund to advance--at the earliest stages of litigation 
when little information regarding the dispute may be readily 
available--an amount that would cover the expenses of an entire 
trial. If a director-defendant requests additional advances from the 
fund, and a reasonable belief determination no longer can be made, 
the fund's board should decline to authorize the advance, unless the 
fund obtained assurances that the advance will be repaid if the 
director ultimately is found to have engaged in disabling conduct.
    \66\ See Release 11330, supra note 59.

---------------------------------------------------------------------------

[[Page 59884]]

D. Compensating Fund Directors With Fund Shares

    The Commission staff believes that effective fund governance can be 
enhanced when funds align the interests of their directors with the 
interests of their shareholders. Fund directors who own shares in the 
funds that they oversee have a clear economic incentive to protect the 
interests of fund shareholders. In addition, as fund shareholders, 
these directors are in a better position to evaluate the services that 
the funds provide to their shareholders.
    Certain funds have instituted policies that encourage or require 
their independent directors to invest the compensation that they 
receive from the funds in shares of the funds.\67\ The Commission staff 
believes that the implementation of such policies gives the independent 
directors a direct and tangible stake in the financial performance of 
the funds that they oversee, and can help more closely align the 
interests of independent directors and fund shareholders. Recently, an 
advisory group organized by the Investment Company Institute 
recommended this practice.\68\
---------------------------------------------------------------------------

    \67\ Some funds have implemented deferred compensation plans for 
directors allowing directors to defer receipt of director fees to 
obtain tax and other benefits. Under these plans, directors can be 
credited with amounts tied to the performance of the funds. See 
Deferred Compensation Plans for Investment Company Directors, supra 
note 52.
    \68\ See ICI Advisory Group Report, supra note 27, at 17.
---------------------------------------------------------------------------

    The staff believes that some fund groups have not instituted these 
policies because of concerns that they may be prohibited by section 
22(g) of the Investment Company Act.\69\ The staff believes that such 
concerns may be misplaced, and would like to clarify the circumstances 
in which open-end funds may (1) encourage or require fund directors to 
purchase fund shares with the compensation that they receive from a 
fund and (2) compensate directors directly with fund shares, consistent 
with section 22(g).
---------------------------------------------------------------------------

    \69\ Id. at n.31.
---------------------------------------------------------------------------

    Prior to the enactment of section 22(g) in 1940, some open-end 
funds issued their shares to fund insiders for providing management, 
promotion, distribution and other services to the funds.\70\ In some 
instances, this practice apparently resulted in the dilution of 
shareholder interests. For example, some funds agreed to pay insiders a 
definite number of shares of the fund at a future date for their 
services (rather than assign a fixed dollar value to the services). If 
the value of the fund's shares appreciated by the time that the shares 
were payable by the fund, the compensation paid to the insiders 
exceeded the value of the services provided. As a result, the fund 
treated the insiders on a basis more favorable than other shareholders 
by allowing them to acquire fund shares at less than the net asset 
value of the shares. The insiders received a ``windfall'' that diluted 
the value of the shares of other shareholders.
---------------------------------------------------------------------------

    \70\ See House Hearings, supra note 4, at 124.
---------------------------------------------------------------------------

    Consequently, Congress enacted section 22(g) to prohibit open-end 
funds from issuing shares to any person or entity that performs 
services for the fund. Section 22(g) generally provides that no open-
end fund shall issue any of its securities (1) for services or (2) for 
property other than cash or securities.\71\ Both the Commission and the 
representatives of investment companies agreed in 1940 that ``[n]o 
security issued by an investment company shall be sold to insiders or 
to anyone other than an underwriter or dealer, except on the same terms 
as are offered to other investors.'' \72\
---------------------------------------------------------------------------

    \71\ Section 22(g) [15 U.S.C. Secs. 80a-22(g)].
    \72\ See House Hearings, supra note 4, at 99 (memorandum of 
agreement in principle between the Commission and representatives of 
open-end and closed-end investment companies dated May 13, 1940).
---------------------------------------------------------------------------

    As previously mentioned, some open-end funds have instituted 
policies that encourage or require their independent directors to 
invest their compensation in the shares of the funds that they oversee. 
Under these policies, a fixed dollar value is assigned to the services 
provided by the directors prior to the time that the directors perform 
any services or purchase the funds' shares. The directors' fees, 
therefore, cannot be inflated by allowing directors to receive fund 
shares with an aggregate net asset value that exceeds the dollar value 
that was previously assigned to the directors' services. The staff 
believes that, under these circumstances, funds may institute policies 
that encourage or require their directors to purchase fund shares with 
the compensation that the directors receive from the funds, consistent 
with section 22(g).\73\
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    \73\ Closed-end funds also may wish to institute policies that 
encourage or require their directors to use the compensation that 
they receive from the funds to purchase fund shares in the secondary 
market on the same basis as other fund shareholders. The staff 
believes that these policies would be consistent with section 23(a) 
of the Investment Company Act. Section 23(a) [15 U.S.C. Sec. 80a-
23(a)]. Like section 22(g), section 23(a) prohibits a closed-end 
fund from issuing any of its securities (1) for services or (2) for 
property other than cash or securities.
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    In addition, the staff would not recommend enforcement action to 
the Commission under section 22(g) if funds directly compensate their 
directors with fund shares, rather than compensating the directors in 
cash and requiring them subsequently to purchase fund shares, provided 
that a fixed dollar value is assigned to the directors' services prior 
to the time that the compensation is payable.\74\ The staff similarly 
believes that this method of compensation, which is functionally 
equivalent to paying the directors in cash, does not present the 
dangers of dilution and the overvaluation of services that section 
22(g) was designed to prevent.
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    \74\ Similarly, the staff would not recommend enforcement action 
to the Commission under section 23(a) if closed-end funds directly 
compensate their directors with fund shares, provided that the 
directors' services are assigned a fixed dollar value prior to the 
time that the compensation is payable. Closed-end funds, however, 
are generally prohibited by section 23(b) of the Investment Company 
Act from selling their shares at a price below their current net 
asset value. Section 23(b) [15 U.S.C. Sec. 80a-23(b)]. As a result, 
any closed-end fund that compensates its directors by issuing fund 
shares would generally be required to issue those shares at net 
asset value, even if the shares are trading at a discount to their 
net asset value.
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    In implementing these policies, funds should ensure that their 
directors purchase their shares from the funds on the same basis as 
other shareholders, and not on preferential terms.\75\ Funds also 
should disclose the directors' compensation structure and the dollar 
amount or value of their compensation to current and prospective fund 
shareholders in registration statements, shareholder reports and proxy 
statements, as required by the federal securities laws.
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    \75\ A fund may sell its shares to its directors at prices that 
reflect scheduled variations in, or the elimination of, any sales 
load pursuant to rule   22d-1 under the Act [17 CFR 270.22d-1].
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III. The Role of the Commission in Disputes Between Independent 
Fund Directors and Fund Management

    Over the past few years, the Commission has been criticized for not 
taking certain actions in connection with disputes between independent 
fund directors and fund management.\76\ Specifically, some persons have 
suggested that the Commission should have taken action against certain 
investment advisers based on allegations made by funds' independent 
directors that the advisers had violated the federal securities laws. 
We believe that these suggestions may reflect confusion regarding the 
significance that should be attached to the Commission's public 
silence, or

[[Page 59885]]

determination not to institute an enforcement action, in the face of 
allegations of violations of the federal securities laws. Indeed, as 
discussed below, no one should presume that the Commission has not 
carefully considered such allegations or that the Commission has failed 
to take appropriate action merely because the Commission has not 
instituted an enforcement action or taken other public actions.
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    \76\ See, e.g., Charles Jaffe, An oversight on oversight; SEC 
wants directors to stand by shareholders, but won't help them, 
Boston Globe, Feb. 28, 1999, at D6; and Edward Wyatt, SEC Explores 
Directors' Roles, N.Y. Times, Jan. 31, 1999, at S3.
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    Two principles are important to understanding the Commission's 
response to disputes between independent fund directors and fund 
management. First, the Commission's staff may conduct an examination or 
investigation, but the public generally will be unaware of such action. 
As a matter of policy, the Commission and its staff generally will not 
comment on the existence or non-existence of a particular examination 
or investigation, or disclose publicly any actions taken in connection 
with an examination or investigation, unless the Commission institutes 
an enforcement action.\77\ This policy is necessary to protect both the 
integrity of an examination or investigation against premature 
disclosure, and the personal privacy of individuals against whom others 
may make unfounded charges. Second, the Commission and its staff may 
decide that enforcement action is not warranted based on all available 
information, including information to which commentators and others are 
not privy, even though publicly available information may suggest that 
a federal securities law violation has occurred. Thus, a decision by 
the Commission not to institute an enforcement action may be based on 
nonpublic, exculpatory information, and the Commission's policies 
preclude it from disclosing this information or explaining its decision 
to the public. It therefore is wrong to presume, merely because the 
Commission has not made any public statement or taken any public action 
in connection with an internal fund dispute, that the Commission has 
not investigated any allegations made by the parties or failed to take 
appropriate action in view of all available facts.\78\
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    \77\ The Commission's rules require that both informal and 
formal investigations be non-public. 17 CFR 202.5 and 203.5. Section 
210(b) of the Investment Advisers Act of 1940 (``Advisers Act'') [15 
U.S.C. Sec. 80b-10(b)] generally prohibits the Commission and its 
staff from disclosing the existence of, and information obtained as 
a result of, an examination of an investment adviser under the Act. 
Further, records or information that are obtained in the course of 
an investigation or examination generally are exempt from disclosure 
under the Freedom of Information Act. Exemptions 7 and 8 of the 
Freedom of Information Act [5 U.S.C. Secs. 552(b)(7), (8)].
    \78\ See Roundtable Transcript of Feb. 23, 1999, at 25 
(statement of Arthur Levitt, Chairman, SEC) (the Commission ``will 
aggressively and vigorously pursue reports by directors of 
violations of federal law and not sit idly by''); Roundtable 
Transcript of Feb. 24, 1999, at 207-208 (statement of Paul Roye, 
Director, Division of Investment Management, SEC) (allegations of 
violations of federal securities laws will be resolutely pursued).
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    We also believe that it would be helpful to clarify the 
Commission's role and procedures in connection with disputes between 
independent fund directors and fund management. The Commission's role, 
as a general matter, is to interpret, administer and enforce the 
federal securities laws for the protection of investors. Accordingly, 
the Commission's role in connection with internal fund disputes 
generally is to provide guidance regarding the requirements of the 
federal securities laws, investigate possible violations of these laws, 
and institute enforcement actions in appropriate circumstances when the 
Commission believes that these laws have been violated. While there may 
be instances in which the Commission, in fulfilling this role, may 
indirectly assist one party in a dispute, the Commission generally will 
not mediate private disputes, side with one party over another, or seek 
to effect a particular outcome. Rather, the Commission will assist the 
parties to understand the requirements of the federal securities laws, 
evaluate all allegations of violations of those laws, and take 
appropriate action for the protection of investors.
    As a general matter, the procedures followed by the Commission and 
the staff in connection with internal fund disputes are similar to the 
procedures that it follows in connection with any private dispute that 
involves the application of, and compliance with, the federal 
securities laws. As a matter of practice, the Commission affords 
substantial consideration to all such allegations of violations and 
promptly assigns staff to carefully evaluate them. During this initial, 
informal evaluation, the staff typically will review public documents, 
such as registration statements and other Commission filings, and may 
invoke the Commission's examination authority to review fund records, 
including board minutes, or the records of the fund's investment 
adviser.\79\ The staff also may ask interested parties, including 
independent and interested directors, fund officers, and investment 
advisory personnel, to cooperate voluntarily by agreeing to provide 
additional information and documents to the staff. If more information 
is needed, the staff may conduct an investigation and, if necessary, 
the Commission may issue a formal order of investigation. Under a 
formal order, the Commission authorizes the staff to conduct an 
investigation, pursuant to which the staff may subpoena witnesses and 
compel the production of documents.\80\ This information gathering is 
critical to the Commission's determination of the appropriate course of 
action, for it often uncovers exculpatory or inculpatory nonpublic 
information that bears upon the validity of the allegations.
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    \79\ See Section 31(b) of the Act [15 U.S.C. Sec. 80a-30(b); 
Section of the Advisers Act [15 U.S.C. Sec. 80b04].
    \80\ See Section 42(b) of the Act [15 U.S.C. Sec. 80a-41(b)]; 
Section 209(b) of the Advisers Act [15 U.S.C. Sec. 80b-9(b)].
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    The Commission may take more serious steps if the public interest 
so requires. For example, if the Commission finds evidence of serious 
violations of the federal securities laws, it may institute 
administrative proceedings or initiate an action in federal district 
court.\81\ In some circumstances, the staff may refer the matter to the 
Department of Justice to consider whether criminal charges are 
warranted.
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    \81\ Section 36(a) of the Act [15 U.S.C. (80a-35(a)] authorizes 
the Commission to institute an action in federal district court 
against certain individuals for breaches of fiduciary duties 
involving personal misconduct regarding a registered investment 
company. Section 36(b) [15 U.S.C. (80a-35(b)] authorizes the 
Commission to institute an action in federal district court against 
an investment adviser for breach of fiduciary duty in connection 
with its receipt of compensation from a registered investment 
company. The Commission also may institute other actions in federal 
district court pursuant to Section 42(d) of the Act [15 U.S.C. (80a-
41(d)] and Section 209(d) of the Advisers Act [15 U.S.C. (80b-9(d)]. 
Administrative proceedings may be instituted under Section 9 of the 
Act [15 U.S.C. (80a-9] and Section 203 of the Advisers Act [15 
U.S.C. (80b-3].
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    The Commission's role in disputes between independent fund 
directors and fund management will not necessarily involve an 
examination or investigation. If, for example, the parties disagree as 
to the correct interpretation of some provision of the federal 
securities laws and regulations, or the parties need further 
clarification of particular legal issues, the staff may provide its 
interpretation of the provision or its views regarding the issue in 
question, either in writing or orally. The Commission also may file a 
friend-of-the-court brief in ongoing litigation, or otherwise seek to 
intervene in private litigation when it believes that its views on 
certain matters may be

[[Page 59886]]

helpful to the court or necessary for the protection of investors.\82\
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    \82\ See, e.g., discussion of Letter from Jacob H. Stillman and 
Douglas Scheidt to Richard Teigen, Esq., et. al, October 16, 1998, 
supra note 51 and accompanying text; and discussion of The Yacktman 
Funds, Inc., SEC No-Action Letter (Dec. 18, 1998), supra note 64 and 
accompanying text. See also Section 44 of the Act [15 U.S.C. 
Sec. 80a-43] (authorizing the Commission to intervene in private 
litigation brought under Section 36(b) of the Act) [15 U.S.C. 
Sec. 80a-35(b)]). See also statements of Commission Chairman Arthur 
Levitt: regarding the need for the fund industry to assume an active 
role in establishing and promoting best fund governance practices, 
supra note 27, and expressing concerns about standard ``insured 
versus insured'' exclusions in joint insurance policies. See 
Companion Release, supra note 2, n.111; and supra note 56.
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    As described above, the Commission and the staff are committed to 
carefully reviewing all allegations of violations of the federal 
securities laws, and taking appropriate action when a violation has 
occurred. The Commission's and the staff's actions, and any decisions 
not to act, will be based on all facts that are available to us, and 
will not necessarily be explained to the public. These positions are 
necessary to ensure the fairness and integrity of the examination and 
investigative process. The Commission and the staff also are dedicated 
to enhancing the fairness and integrity of the fund governance process, 
and will consider instituting enforcement proceedings or taking other 
public positions if they will further this goal.

List of Subjects in 17 CFR Part 271

    Investment companies.

Amendment of the Code of Federal Regulations

    For the reasons set out in the preamble, title 17 chapter II of the 
Code of Federal Regulations is amended as set forth below:

PART 271--INTERPRETATIVE RELEASES RELATING TO THE INVESTMENT 
COMPANY ACT OF 1940 AND GENERAL RULES AND REGULATIONS THEREUNDER

    1. Part 271 is amended by adding Release No. IC-24083 and the 
release date of October 14, 1999, to the list of interpretive releases.

    Dated: October 14, 1999.

    By the Commission.
Jonathan G. Katz,
Secretary.
[FR Doc. 99-27443 Filed 11-2-99; 8:45 am]
BILLING CODE 8010-01-P