[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\
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\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.
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\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\
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\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.
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\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.
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[[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\
---------------------------------------------------------------------------
\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