[Federal Register Volume 69, Number 147 (Monday, August 2, 2004)]
[Rules and Regulations]
[Pages 46378-46393]
From the Federal Register Online via the Government Publishing Office [www.gpo.gov]
[FR Doc No: 04-17460]



[[Page 46377]]

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Part IV





Securities and Exchange Commission





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17 CFR Part 270



Investment Company Governance; Final Rule

  Federal Register / Vol. 69, No. 147 / Monday, August 2, 2004 / Rules 
and Regulations  

[[Page 46378]]


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SECURITIES AND EXCHANGE COMMISSION

17 CFR Part 270

[Release No. IC-26520; File No. S7-03-04]
RIN 3235-AJ05


Investment Company Governance

AGENCY: Securities and Exchange Commission.

ACTION: Final rule.

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SUMMARY: The Securities and Exchange Commission (``Commission'') is 
adopting amendments to rules under the Investment Company Act of 1940 
to require investment companies (``funds'') that rely on certain 
exemptive rules to adopt certain governance practices. The amendments 
are designed to enhance the independence and effectiveness of fund 
boards and to improve their ability to protect the interests of the 
funds and fund shareholders they serve.

DATES: Effective date: September 7, 2004.
    Compliance date: January 16, 2006.

FOR FURTHER INFORMATION CONTACT: Catherine E. Marshall, Attorney, 
Office of Investment Adviser Regulation, (202) 942-0719; C. Hunter 
Jones, Assistant Director, Office of Regulatory Policy, (202) 942-0690, 
Division of Investment Management, Securities and Exchange Commission, 
450 Fifth St., NW, Washington, DC 20549-0506.

SUPPLEMENTARY INFORMATION: The Commission is adopting amendments to: 
rules 0-1(a) [17 CFR 270.0-1(a)]; 10f-3 [17 CFR 270.10f-3]; 12b-1(c) 
[17 CFR 270.12b-1(c)]; 15a-4(b)(2) [17 CFR 270.15a-4(b)(2)]; 17a-7(f) 
[17 CFR 270.17a-7(f)]; 17a-8(a)(4) [17 CFR 270.17a-8(a)(4)]; 17d-
1(d)(7) [17 CFR 270.17d-1(d)(7)]; 17e-1(c) [17 CFR 270.17e-1(c)]; 17g-
1(j)(3) [17 CFR 270.17g-1(j)(3)]; 18f-3(e) [17 CFR 270.18f-3(e)]; 23c-
3(b)(8) [17 CFR 270.23c-3(b)(8)]; and 31a-2 [17 CFR 270.31a-2] under 
the Investment Company Act of 1940 [15 U.S.C. 80a] (the ``Investment 
Company Act'' or the ``Act'').\1\
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    \1\ Unless Otherwise noted, all references to statutory sections 
are to the Investment Company act of 1940.
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Table of Contents

I. Background
II. The Role of Independent Directors
    A. Managing Conflicts of Interest
    B. Approving the Advisory Contract and Advisory Fees
    C. Selecting and Nominating Candidates for Independent Directors
III. Discussion of New Rules
    A. Board Composition
    B. Independent Chairman of the Board
    C. Annual Self-Assessment
    D. Separate Sessions
    E. Independent Director Staff
    F. Recordkeeping for Approval of Advisory Contracts
IV. Effective Date; Compliance Date
V. Paperwork Reduction Act
VI. Cost-Benefit Analysis
VII. Final Regulatory Flexibility Analysis
VIII. Consideration of Promotion of Efficiency, Competition and 
Capital Formation
Statutory Authority
Text of Rules

I. Background

    In January 2004, the Commission proposed amendments to improve the 
governance standards of investment companies (i.e., funds).\2\ These 
amendments provide for greater independence of fund boards in the case 
of funds that rely upon certain exemptive rules that allow funds to 
engage in transactions that would otherwise be prohibited under the 
Investment Company Act and that present conflicts of interest between 
the fund and its management company. These amendments expand upon the 
fund governance amendments we adopted in 2001, which require that any 
fund that relies upon those exemptive rules must have a governance 
structure that provides, among other things, for a board that has a 
majority of independent directors.\3\ In light of recent developments, 
we now believe that the 2001 amendments do not go far enough in 
addressing the need for independent fund boards.\4\
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    \2\ Investment Company Governance, Investment Company Act 
Release No. 26323 (Jan. 15, 2004) [69 FR 3472 (Jan. 23, 2004)] 
(``Proposing Release''). In 2001, we adopted amendments that require 
any fund that relies upon certain exemptive rules to have (i) a 
board that has a majority of independent directors; (ii) the 
independent directors select and nominate independent directors; and 
(iii) independent directors, if they hire counsel, hire only counsel 
that does not have substantial ties to fund managers. Role of 
Independent Directors of Investment Companies, Investment Company 
Act Release No. 24816 (Jan. 2, 2001) [66 FR 3734 (Jan. 16, 2001)] 
(``2001 Adopting Release'').
    \3\ In this Release we are using ``independent director'' to 
refer to a director who is not an ``interested person'' of the fund, 
as defined by the Act. See infra note 23.
    \4\ As one commenter on the proposal noted, ``The current 
requirement for a bare majority of independent directors does not 
adequately assure that these directors will dominate the decision-
making process.'' Letter from Consumer Federation of America, et 
al., to Jonathan G. Katz, Secretary, SEC (Mar. 10, 2004), File No. 
S7-03-04 (``Consumer Federation Letter'').
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    We proposed these rule amendments, along with a number of other 
initiatives,\5\ in the wake of a troubling series of enforcement 
actions involving late trading of mutual fund shares, inappropriate 
market timing activities, and misuse of nonpublic information about 
fund portfolios.\6\ When we

[[Page 46379]]

proposed these amendments, we expressed concern that the enforcement 
actions in many cases reflected a serious breakdown in management 
controls. We observed that, in some cases, the fund was used for the 
benefit of fund insiders, often the management company or its 
employees. In addition, we had recently adopted a new rule creating the 
position of fund chief compliance officer, which reports directly to 
the board on compliance matters.\7\ The proposed fund governance 
standards would complement that rule by placing fund boards in a better 
position to demand that management adhere to the highest of compliance 
standards.
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    \5\ See, e.g., Disclosure Regarding Approval of Investment 
Advisory Contracts by Directors of Investment Companies, Investment 
Company Act Release No. 26350 (Feb. 11, 2004) [69 FR 7852 (Feb. 19, 
2004)] (proposing release) and 26486 (June 23, 2004) [69 FR 39798 
(June 30, 2004)] (adopting release); Investment Adviser Codes of 
Ethics, Investment Company Act Release No. 26337 (Jan. 20, 2004) [69 
FR 4040 (Jan. 27, 2004)] (proposing release) and 26492 (July 2, 
2004) [69 FR 41696 (July 9, 2004)] (adopting release); Disclosure of 
Breakpoint Discounts by Mutual Funds, Investment Company Act Release 
Nos. 26298 (Dec. 17, 2003) [68 FR 74732 (Dec. 24, 2003)] (proposing 
release) and 26464 (June 7, 2004) [69 FR 33262 (June 14, 2004)] 
(adopting release) (``Breakpoint Disclosure''); Disclosure Regarding 
Market Timing and Selective Disclosure of Portfolio Holdings, 
Investment Company Act Release Nos. 26287 (Dec. 11, 2003) [68 FR 
70402 (Dec. 17, 2003)] (proposing release) and 26418 (Apr. 19, 2004) 
[69 FR 22300 (Apr. 23, 2004)] (adopting release) (``Market Timing 
Disclosure''); Mandatory Redemption Fees for Redeemable Fund 
Securities, Investment Company Act Release No. 26375A (Mar. 5, 2004) 
[69 FR 11762 (Mar. 11, 2004)]; Prohibition on the Use of Brokerage 
Commissions to Finance Distribution, Investment Company Act Release 
No. 26356 (Feb. 24, 2004) [69 FR 9726 (Mar. 1, 2004)]; Amendments to 
Rules Governing Pricing of Mutual Fund Shares, Investment Company 
Act Release No. 26288 (Dec. 11, 2003) [68 FR 70388 (Dec. 17. 2003)].
    \6\ See, e.g., In the Matter of Alliance Capital Management, 
L.P., Investment Company Act Release No. 26312A (Jan. 15, 2004) 
(finding that an investment adviser violated its fiduciary duty to 
the fund by failing to disclose agreements, and making special 
accommodations, to permit select investors to engage in market 
timing transactions in exchange for the maintenance of ``sticky 
assets,'' and finding that the investment adviser divulged material 
nonpublic information about portfolio holdings); In the Matter of 
Putnam Investment Management, LLC, Investment Company Act Release 
No. 26255 (Nov. 13, 2003) (finding that an investment adviser failed 
to disclose potentially self-dealing transactions in shares of funds 
managed by several of its employees, failed to have procedures 
reasonably designed to prevent misuse of material nonpublic 
information, and failed to reasonably supervise the employees who 
committed violations); In the Matter of James Patrick Connelly Jr., 
Investment Company Act Release No. 26209 (Oct. 16, 2003) (finding 
that a former executive of an investment adviser to a fund complex 
approved agreements that permitted select investors to engage in 
market timing transactions in certain funds in the complex, in 
exchange for the maintenance of sticky assets); In the Matter of 
Steven B. Markovitz, Investment Company Act Release No. 26201 (Oct. 
2, 2003) (finding that a former hedge fund trader violated the 
federal securities laws and defrauded investors by engaging in late 
trading of mutual fund shares). See also In the Matter of Pilgrim 
Baxter & Associates, Ltd., Investment Company Act Release No. 26470 
(June 21, 2004) (finding that the investment adviser violated the 
federal securities laws by failing to disclose to funds' board of 
directors or shareholder that its principal was engaged in self-
dealing transactions through significant ownership stake in a hedge 
fund engaged in market timing of fund managed by him, by permitting 
market timing despite prospectus disclosure to the contrary, and by 
disclosing material nonpublic portfolio information to a broker-
dealer whose customers engaged in market timing the funds); In the 
Matter of Strong Capital Management, Inc., Investment Company Act 
Release No. 26409 (May 20, 2004) (finding that investment adviser 
violated its fiduciary duties to the funds by (i) failing to 
disclose to the funds' boards or shareholders the conflicts of 
interest created when the adviser allowed hedge fund to market time 
certain funds and that the chairman frequently traded certain funds, 
including a fund for which he served as portfolio manager, (ii) 
providing hedge fund manager nonpublic portfolio information for 
certain funds, and (iii) filing fund prospectuses that failed to 
disclose that the adviser would make exceptions to the disclosed 
policies discouraging market timing in instances where the fund's 
chairman or the adviser benefited); In the Matter of Massachusetts 
Financial Services Company, Investment Company Act Release No. 26409 
(Mar. 31, 2004) (sanctioning fund investment adviser for failing to 
disclose to the fund board that the adviser had entered into 
arrangements with approximately 100 broker-dealers under which the 
fund adviser agreed to make certain cash payments or direct fund 
brokerage to certain broker-dealers in return for preferred 
treatment in promoting fund sales).
    \7\ Compliance Programs of Investment Companies and Investment 
Advisers, Investment Company Act Release No. 26299 (Dec. 17, 2003) 
[68 FR 74714 (Dec. 24, 2003)] (``Compliance Programs'').
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    Our proposed rules also reflected broader concerns with the 
governance of mutual funds. We noted that the Act and our rules rely 
heavily on fund boards of directors to manage the conflicts of interest 
that advisers have with funds they manage. We noted that a fund adviser 
is frequently in a position to dominate the board because of the 
adviser's monopoly over information about the fund and its frequent 
ability to control the board's agenda. We questioned the ability of a 
management-dominated board to undertake the many important tasks 
assigned to the board by the Act and our rules, including negotiating 
the advisory fee, approving a 12b-1 plan, and resolving conflicts 
between the fund and the management company.\8\
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    \8\ Directors are generally responsible under state law for the 
oversight of all of the operations of a mutual fund, and the 
Investment Company Act assigns many specific responsibilities to 
fund boards. For example, fund boards must evaluate and approve a 
fund's advisory contract and may unilaterally terminate the 
contract. See section 15 of the Act [15 U.S.C. 80a-15].
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    We proposed to amend ten commonly used exemptive rules under the 
Investment Company Act (``Exemptive Rules'') \9\ to require the funds 
relying on those rules to follow improved governance standards.\10\ 
These rules rely on the independent judgment and scrutiny of directors, 
including independent directors, in overseeing activities that are 
beneficial to funds and fund shareholders but that involve inherent 
conflicts of interest between the funds and their managers. These are 
the same Exemptive Rules that we amended in 2001. These further 
amendments provide for greater fund board independence and are designed 
to enhance the ability of fund boards to perform their important 
responsibilities under each of the rules.\11\
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    \9\ The Exemptive Rules are:
    Rule 10f-3 (permitting a fund to purchase securities in a 
primary offering when an affiliated broker-dealer is a member of the 
underwriting syndicate, if the fund directors, including a majority 
of the independent directors, approve procedures governing the 
purchases and review quarterly reports on purchases);
    Rule 12b-1 (permitting use of fund assets to pay distribution 
expenses pursuant to a plan approved by the fund directors, 
including a majority of the independent directors);
    Rule 15a-4(b)(2) (permitting a fund board to approve an interim 
advisory contract without shareholder approval when the adviser or a 
controlling person receives a benefit in connection with the 
assignment of the contract, if the fund directors, including a 
majority of the independent directors, review and approve the 
contract);
    Rule 17a-7 (permitting securities transactions between a fund 
and another client of the fund investment adviser, if the fund 
directors, including a majority of the independent directors, 
approve procedures governing the transactions and review quarterly 
reports on transactions);
    Rule 17a-8 (permitting mergers between certain affiliated funds 
if the fund directors, including a majority of the independent 
directors, request and evaluate information about the merger and 
determine that the merger is in the best interests of the fund and 
its shareholders);
    Rule 17d-1(d)(7) (permitting a fund and its affiliates to 
purchase joint liability insurance policies if the fund directors, 
including a majority of the independent directors, annually 
determine that the policies are in the best interests of the fund 
and its shareholders);
    Rule 17e-1 (specifying conditions under which a fund may pay 
commissions to affiliated brokers in connection with the sale of 
securities on an exchange, including a requirement that the fund 
directors, including a majority of the independent directors, adopt 
procedures for the payment of the commissions and review quarterly 
reports of any commissions paid);
    Rule 17g-1 (permitting a fund to maintain joint insured bonds 
and requiring fund independent directors to annually approve the 
bond);
    Rule 18f-3 (permitting a fund to issue multiple classes of 
voting stock, if the fund board of directors, including a majority 
of the independent directors, approves a plan for allocating 
expenses to each class); and
    Rule 23c-3 (permitting the operation of an interval fund by 
enabling a closed-end fund to repurchase shares from investors, if 
the directors adopt a repurchase policy for the fund and review fund 
operations and portfolio management in order to assure adequate 
liquidity of investments to satisfy repurchase payments).
    Last October we proposed a new exemptive rule, rule 15a-5, that 
also would be conditioned on meeting the fund governance standards 
that are currently included in these ten exemptive rules. See 
Exemption from Shareholder Approval for Certain Subadvisory 
Contracts, Investment Company Act Release No. 26230 (Oct. 23, 2003) 
[68 FR 61720 (Oct. 29, 2003)]. As we stated when we proposed the 
fund governance amendments we are adopting today, if we adopt rule 
15a-5, we intend to condition its use on compliance with the revised 
fund governance standards. See Proposing Release, supra note 2, at 
n.16.
    \10\ These rules (i) exempt funds or their affiliated persons 
from provisions of the Act that can involve serious conflicts of 
interest and (ii) condition the exemptive relief on the approval or 
oversight of independent directors. See Proposing Release, supra 
note 2, at text accompanying n.16.
    \11\ For the reasons discussed throughout this Release, we 
believe that amending the Exemptive Rules to provide for greater 
board independence and to enhance a board's ability to perform the 
responsibilities under those rules is necessary and appropriate in 
the public interest and is consistent with the protection of 
investors and the purposes of the Act. See, e.g., section 6(c) 
(authority of the Commission to conditionally exempt a person or 
transaction if it is ``necessary or appropriate in the public 
interest and consistent with the protection of investors and the 
purposes fairly intended by the policy and provisions of this 
title.''). Each of the Exemptive Rules permits a fund to engage in 
transactions or conduct that presents significant conflicts of 
interest and that otherwise would be restricted or prohibited by the 
Act. As the Commission already determined when it made similar 
amendments to the Exemptive Rules in 2001, establishing conditions 
for the Exemptive Rules based on the independence of the fund board 
is appropriate to address the types of conflicts Congress identified 
in the Act. The amendments therefore are well within the 
Commission's broad authority to ``conditionally or unconditionally 
exempt any person, security, or transaction'' from any provision of 
the Act. See also infra Statutory Authority section.
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    The proposal engendered a substantial amount of interest. We 
received nearly 200 comments from fund investors, management companies, 
independent directors to mutual funds, as well as members of Congress. 
We also received several comments from organizations that had a more 
general interest in corporate governance issues. Most commenters 
supported our efforts to strengthen fund governance, but many were 
divided on some of our proposals. Some commenters believed the proposed 
amendments did not go far enough; others recommended certain 
modifications.
    We recognize that these amendments might not have prevented all of 
the abuses that were uncovered in the enforcement actions discussed 
above. Nevertheless, if funds are to engage in the transactions 
permitted by the Exemptive Rules \12\ and effectively

[[Page 46380]]

manage the conflicts of interest inherent in those transactions, 
greater board independence is needed. We are adopting them 
substantially as proposed.
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    \12\ As we stated when we proposed the fund governance 
amendments that we adopted in 2001, the amended rules do not require 
all funds to adopt these measures. Although the Commission urges all 
funds to consider adopting the measures to strengthen the 
independence of their boards, funds that do not rely on any of the 
Exemptive Rules will not be subject to these requirements. See Role 
of Independent Directors of Investment Companies, Investment Company 
Act Release No. 24082 (Oct. 14, 1999) [64 FR 59826 (Nov. 3, 1999)] 
(``1999 Proposing Release'') at text preceding n.34.
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II. The Role of Independent Directors

    Before we discuss the rules we are today adopting, we wish to take 
this opportunity to make some observations about the role of fund 
directors and, in particular, independent directors.

A. Managing Conflicts of Interest

    Fund independent directors play a central role in policing the 
conflicts of interest that advisers inevitably have with the funds they 
advise. Many fine individuals today ably serve investors in this 
capacity. We do not intend that this rulemaking, or the statements we 
have made about the need for reform of the mutual fund regulatory 
framework or mutual fund governance, be construed in any way as a 
challenge to their integrity or commitment to investors. Our efforts 
today are designed to strengthen the role that independent directors 
play and to support their work on behalf of fund shareholders. The 
amendments are intended largely to preserve the current system of fund 
governance that on the whole has served mutual fund investors well, 
while addressing its weaknesses.
    To be truly effective, a fund board must be an independent force in 
fund affairs rather than a passive affiliate of management.\13\ Its 
independent directors must bring to the boardroom ``a high degree of 
rigor and skeptical objectivity to the evaluation of management and its 
plans and proposals,'' particularly when evaluating conflicts of 
interest.\14\ They must commit their time and energy, and devote 
themselves to the principles set forth in the Investment Company Act 
and state corporate and trust law under which the fund is organized.
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    \13\ See Division of Corporation Finance, Securities and 
Exchange Commission, Staff Report on Corporate Accountability (Sept. 
4, 1980) (printed for the use of Senate Committee on Banking, 
Housing, and Urban Affairs, 96th Cong., 2d Sess.) at F2 (noting 
importance of corporate boards of directors in overseeing 
performance of corporate management).
    \14\ Donald C. Langevoort, The Human Nature of Corporate Boards: 
Law, Norms, and the Unintended Consequences of Independence and 
Accountability, 89 Geo. L. J. 797, 798 (2001). ``[T]here are 
industries where the case for independence is compelling. The best 
example here is the mutual fund industry, where conflicts of 
interests are commonplace and traditional checks on managerial 
overreaching, such as vigorous shareholder voting and hostile tender 
offers do not exist.'' Id. at 814.
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    While the Investment Company Act contains many important 
requirements with which a fund must comply, the paramount principle 
that must prevail, and should animate all decisions directors are 
called upon to make, is that a fund must be managed on behalf of its 
investors rather than on behalf of the adviser or other affiliated 
persons of the fund.\15\ Directors should be highly skeptical of 
arguments that merely rationalize the resolution of conflicts in favor 
of the fund adviser, and should seek results that advance the best 
interest of fund shareholders.
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    \15\ Section 1(b)(2) of the Act [15 U.S.C. 80a-1(b)(2)] (``[T]he 
national public interest and the interest of investors are adversely 
affected * * * (2) when investment companies are organized, 
operated, managed, or their portfolio securities are selected, in 
the interest of directors, officers, investment advisers, 
depositors, or other affiliated persons thereof, in the interest of 
underwriters, brokers, or dealers, in the interest of special 
classes of their security holders, or in the interest of other 
investment companies or persons engaged in other lines of business, 
rather than in the interest of all classes of such companies' 
security holders * * * '').
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B. Approving the Advisory Contract and Advisory Fees

    Section 15(c) of the Act prohibits a person from serving as an 
investment adviser to a fund except pursuant to a contract that has 
been approved by a majority of directors who are not parties to the 
contract or interested persons of any such party, i.e., the independent 
directors. Section 15(c) requires fund boards to consider whether to 
approve the terms of the contract, including the amount of the advisory 
fee based on, among other things, information provided by the fund 
adviser. These procedural requirements do not supplant the state law 
duties of loyalty and care that oblige directors to act in the best 
interest of the fund when considering important matters the Act 
entrusts to them, such as approval of an advisory contract and the 
advisory fee.\16\ Nor does the disclosure of the advisory fee in the 
prospectus relieve the independent directors of the obligation to 
negotiate the amount of the fee and assure that fund shareholders share 
in the economies of scale achieved by the growth in fund assets, by, 
when appropriate, reducing advisory fees.\17\
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    \16\ See S. Rep. No. 91-184, at 4902-03 (1969) (``The directors 
of a mutual fund, like directors of any other corporation, will 
continue to have * * * overall fiduciary duties as directors for the 
supervision of all of the affairs of the fund.''); Burks v. Lasker, 
441 U.S. 471, 478-79 (1979) (``The [Investment Company Act] does not 
purport to be the source of authority for managerial power; rather, 
the Act functions primarily to `[impose] controls and restrictions 
on the internal management of investment companies.' * * * The ICA 
and the [Investment Advisers Act] * * * do not require that federal 
law displace state laws governing the powers of directors unless the 
state laws permit action prohibited by the Acts, or unless `their 
application would be inconsistent with the federal policy underlying 
the cause of action' * * *.'') (emphasis in original) (citations 
omitted). See also Green v. Fund Asset Management, L.P., 245 F.3d 
214, 226 (3d Cir. 2001).
    \17\ See Stanley J. Friedman, The Role of Outside Directors in 
Negotiating Investment Company Advisory Agreements, 24 Rev. Sec. & 
Commod. Reg. 49, 57 (1991) (``[T]he negotiation of investment 
advisory agreements and renewals is a [serious] business in which 
the participation of independent directors who are `qualified, fully 
informed, and * * * conscientious' will not only benefit the 
investment company and its shareholders but will also greatly 
enhance the position of the investment adviser in litigation.''); 
American Bar Association, Fund Director's Guidebook, 59 Bus. Law. 
201, 223 (2003) (``The 1940 Act contains important provisions 
governing the relationship between the adviser and the fund's board 
of directors in negotiating an advisory contract.'') (emphasis 
added); David A. Sturms, Mutual Fund Regulation, Part III: 
Regulation of the Adviser and the Fund Portfolio, PLIREF-MFR Sec.  
6:7 (2002) (``[T]he 1940 Act sets forth a specific framework for 
governing the relationship between the adviser and the fund's board 
of directors in negotiating an advisory contract.'') (emphasis 
added); Review of Current Investigations and Regulatory Actions 
Regarding the Mutual Fund Industry: Fund Operations And Governance: 
Hearings before the Senate Committee on Banking, Housing, and Urban 
Affairs, 108th Cong., 2d Sess., 7-8 (Feb. 26, 2004) (statement of 
David S. Ruder, Professor, Northwestern University School of Law 
(``[Fund directors] must bargain with the adviser regarding the 
costs of its services * * *'')) (http://banking.senate.gov/files/ruder.pdf). See also Schuyt v. Rowe Price Prime Reserve Fund, Inc., 
663 F. Supp. 962, 986 (S.D.N.Y. 1987) (``This is not a case where a 
contract was rubber-stamped by docile individuals; this is a case 
where competent, aggressive individuals analyzed the facts and 
actively bargained to obtain a better deal for the Fund.'') 
(emphasis added); SEC, Public Policy Implications of Investment 
Company Growth, reprinted in H.R. Rep. No. 89-2337, at 127 (1966) 
(``Advisory Fees and the Limitations of Disclosure'').
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    Section 15(c) also provides that the directors of a fund have a 
duty to request and evaluate, and the investment adviser has a duty to 
furnish, the information reasonably necessary to evaluate the terms of 
an advisory contract. Directors should frame their information requests 
broadly to obtain complete information relevant to their consideration 
of the advisory contract, and should include inquiries related to the 
adviser's material conflicts of interest with the fund and how the 
adviser deals with those conflicts. Regardless of the scope of the 
information request, fund advisers have an affirmative obligation under 
section 206 of the Advisers Act to disclose material information 
regarding conflicts of interest to the fund and its board.\18\
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    \18\ 15 U.S.C. 80b-6. See SEC v. Capital Gains Research Bureau, 
Inc., 375 U.S. 180, 201 (1963) (noting that an investment adviser 
may not trade on the market effect of his recommendations without 
``fully and fairly revealing his personal interests in these 
recommendations to his clients''); Vernazza v. SEC, 327 F.3d. 851, 
860 (9th Cir. 2003) (noting that investment advisers had a duty to 
disclose any potential conflicts of interest accurately and 
completely). See also In the Matter of Putnam Investment Management, 
LLC, supra note 6.
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    We reiterate our statement in the Proposing Release that fund

[[Page 46381]]

shareholders stand to benefit substantially when the process of 
negotiation between fund independent directors and investment advisers 
leads to lower fees.\19\ We reaffirm the views we expressed in a 
statement accompanying a recently settled enforcement proceeding, that 
the best way to ensure that funds obtain fair and reasonable fees is 
through a marketplace of vigorous, independent and diligent mutual fund 
boards, coupled with fully informed investors who are armed with 
complete, easy-to-digest disclosure about the fees paid and the 
services rendered.\20\ We have recently adopted and proposed new 
disclosure requirements designed to provide fund investors with this 
information.\21\
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    \19\ Proposing Release, supra note 2, at n.30 and accompanying 
text.
    \20\ See Statement of the Commission Regarding the Enforcement 
Action Against Alliance Capital Management, L.P., SEC Press Release 
2003-176 (Dec. 18, 2003).
    \21\ See, e.g., Market Timing Disclosure, supra note 5; 
Breakpoint Disclosure, supra note 5; Shareholder Reports and 
Quarterly Portfolio Disclosure of Registered Management Investment 
Companies, Investment Company Act Release No. 26372 (Feb. 27, 2004) 
[69 FR 11244 (Mar. 9, 2004)]; Confirmation Requirements and Point of 
Sale Disclosure Requirements for Transactions in Certain Mutual 
Funds and Other Securities, and Other Confirmation Requirement 
Amendments, and Amendments to the Registration Form for Mutual 
Funds, Investment Company Act Release No. 26341 (Jan. 29, 2004) [69 
FR 6438 (Feb. 10, 2004)]; Fund of Funds Investments, Investment 
Company Act Release No. 26198 (Oct. 1, 2003) [68 FR 58226 (Oct. 8, 
2003)].
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C. Selecting and Nominating Candidates for Independent Directors

    The incumbent independent directors of most funds have the 
responsibility to select and nominate new independent directors.\22\ 
The Investment Company Act provides minimum criteria for persons to 
qualify as independent directors, and independent directors who satisfy 
those criteria meet the requirements of the Act.\23\ We urge 
independent directors to look beyond those requirements and examine 
whether a candidate's personal or business relationships suggest that 
the candidate will not aggressively represent the interests of fund 
investors. Persons who have served as executives of the fund adviser or 
who are close family members of employees of the fund, its adviser or 
principal underwriter would, in our view, be poor choices for 
candidates, although they may meet the minimum statutory 
requirements.\24\ We recognize that ``legal'' independence does not 
equate with ``real'' independence. We therefore encourage independent 
directors, in selecting and nominating other independent directors, to 
identify individuals who have the background, experience, and 
independent judgment to represent the interests of fund investors.\25\
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    \22\ As in effect before these amendments, the Exemptive Rules 
have required that, for any fund relying on any of the rules, the 
independent directors must select and nominate other independent 
directors of the fund. See, e.g., rule 10f-3(c)(11)(i) [17 CFR 
270.10f-3(c)(11)(i)]. Before we proposed to amend the Exemptive 
Rules in 1999, we had already included a similar condition in rule 
12b-1 and rule 23c-3. See Bearing of Distribution Expenses by Mutual 
Funds, Investment Company Act Release No. 11414 (Oct. 28, 1980) [45 
FR 73898 (Nov. 7, 1980)]; Repurchase Offers By Closed-End Management 
Investment Companies, Investment Company Act Release No. 19399 (Apr. 
7, 1993) [58 FR 19330 (Apr. 14, 1993)]. See also 1999 Proposing 
Release, supra note 11, at n.30.
    \23\ In this Release we are using ``independent director'' to 
refer to a director who is not an ``interested person'' of the fund, 
as defined by the Act. Section 2(a)(19) of the Act [15 U.S.C. 80a-
2(a)(19)] defines ``interested person'' of a fund to include (i) any 
affiliated person of the fund; (ii) any member of the immediate 
family of any natural person who is an affiliated person of the 
fund; (iii) any interested person of any investment adviser of or 
principal underwriter for the fund; (iv) any person, or partner or 
employee of any person, who acted as legal counsel for the fund 
during the last two completed fiscal years of the fund; (v) any 
person who executed portfolio transactions for the fund or loaned 
money or property to the fund during the past six months, or any 
affiliated person of such a person; and (vi) any natural person who 
the Commission has determined is an interested person because of his 
or her material business or professional relationship with the fund 
during the past two years.
    \24\ See Investment Company Institute, Report of the Advisory 
Group on Best Practices for Fund Directors: Enhancing A Culture of 
Independence and Effectiveness (June 24, 1999), at 12-13 (``ICI 
Advisory Group Report'') (recommending that former officers or 
directors of a fund's investment adviser, principal underwriter, or 
certain of their affiliates not serve as independent directors of 
the fund); Investment Company Institute, Resolution of the Board of 
Governors of the Investment Company Institute (Oct. 3, 2003) 
(resolving that ICI members adopt practices to disqualify persons 
with certain family relationships from serving as independent 
directors of funds) (http://www.ici.org/issues/dir/03_fund_gov_best_stmt.html).
    \25\ The annual self-assessment performed by the board under the 
amended rules also may enable independent directors to identify 
subject areas, such as valuation of portfolio securities, in which 
the board needs future independent directors to have expertise. See 
infra Section III.C.
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III. Discussion of New Rules

    We are amending the ten Exemptive Rules under the Act \26\ to 
require that any fund that relies upon any of those rules \27\ satisfy 
the fund governance standards set forth in rule 0-1(a)(7): (i) at least 
75 percent of the directors of the fund must be independent directors 
or, if the fund board has only three directors, all but one of the 
directors must be independent directors; (ii) the chairman of the board 
must be an independent director; (iii) the board must perform a self-
assessment at least once annually; (iv) the independent directors must 
meet separately at least once a quarter; and (v) the independent 
directors must be affirmatively authorized to hire their own staff.\28\ 
We are also amending rule 31a-2 as proposed, to require that a fund 
retain copies of written materials that the board considers when 
approving the fund's advisory contract.\29\
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    \26\ See supra note 9.
    \27\ The fund governance conditions of the Exemptive Rules apply 
to investment companies, including registered investment companies 
and business development companies, if they rely on these rules.
    \28\ Rule 0-1(a)(7) [17 CFR 270.0-1(a)(7)], which defines the 
term ``fund governance standards,'' incorporates the following fund 
governance requirements with which funds have had to comply since 
2001 in order to rely upon any of the Exemptive Rules: (i) a fund's 
board must have a majority of independent directors, (ii) the fund's 
independent directors must select and nominate any other independent 
directors, and (iii) any person acting as legal counsel to the 
independent directors must be an ``independent legal counsel.'' See 
2001 Adopting Release, supra note 2. The majority independence 
condition also is being revised to a 75 percent independence 
condition.
    \29\ We are also adopting technical amendments to rule 10f-3 to 
revise certain cross-references within the rule.
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A. Board Composition

    As discussed above, when Congress passed the Investment Company 
Act, it relied on independent directors to protect the interests of 
fund investors. A principal purpose of the amendments is to strengthen 
the independent directors' control of the fund board and its agenda, so 
that the interests of investors are paramount. Although the Exemptive 
Rules currently require a simple majority of the board to be 
independent and the independent directors to separately approve the 
transactions covered by those rules, we are concerned that many boards 
continue to be dominated by their management companies. Accordingly, 
the amendments provide that each fund relying on any Exemptive Rule 
must have a board of directors whose independent directors constitute 
at least 75 percent of the board or, if the fund has only three 
directors, all but one of the directors must be independent.\30\ Most 
commenters supported the 75 percent amendment.\31\ Some commenters 
recommended that we adopt an even higher percentage.\32\ We

[[Page 46382]]

do not believe that we need to go that far--there are good arguments 
for maintaining a management presence on the board. Other commenters 
questioned whether a slightly lower super-majority requirement (e.g., 
two-thirds) would suffice.\33\ We believe the 75 percent requirement 
adopted by Congress in section 15(f) of the Act will better assure that 
the independent directors can carry out their fiduciary 
responsibilities.\34\ This requirement was designed to help resolve 
ongoing conflicts of interest, which can result from the sale of an 
advisory firm.
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    \30\ See rule 0-1(a)(7)(i).
    \31\ We received approximately 98 comments on this proposed 
amendment. Comments were submitted from investors, directors (both 
interested and independent), funds, trade associations, and fund 
service providers.
    \32\ See, e.g., Letter from Tom Walker to Jonathan G. Katz, 
Secretary, SEC (Mar. 9, 2004), File No. S7-03-04 (recommending that 
fund boards be completely independent); Letter from John and Judy 
Hesselberth to Jonathan G. Katz, Secretary, SEC (Feb. 24, 2004), 
File No. S7-03-04 (recommending that the percentage be 100%).
    \33\ See, e.g., Letter from Association for Investment 
Management and Research to Jonathan G. Katz, Secretary, SEC (Mar. 
19, 2004), File No. S7-03-04.
    \34\ See, e.g., Letter from John E. Murray, Jr., Lead Director, 
The Federated Funds, to Jonathan G. Katz, Secretary SEC (Mar. 11, 
2004), File No. S7-03-04 (``Murray Letter''). A few commenters 
recommended that the independence requirements established by the 
Investment Company Act be tightened. Letter from Independent 
Directors of the Vanguard Funds to Jonathan G. Katz, Secretary, SEC 
(Mar. 10, 2004), File No. S7-03-04. See section 2(a)(19) (definition 
of ``interested person'').
---------------------------------------------------------------------------

    Requiring that each fund that relies upon any Exemptive Rule have a 
board of directors whose independent directors constitute at least 75 
percent of the board, will help ensure that independent directors carry 
out their fiduciary responsibilities. Management controls the day-to-
day activities of the fund and has significantly greater access to 
information about the fund than do the independent directors. This 
information gives the management directors a significant advantage over 
the independent directors in setting the board's agenda and potentially 
dominating board deliberations. The amendments seek to resolve this 
imbalance. As one commenter noted, ``For fund boards to have 
credibility as they fulfill this responsibility, the board must be 
firmly under the control of those directors whose sole responsibility 
is to look out for the interests of shareholders.'' \35\
---------------------------------------------------------------------------

    \35\ Consumer Federation Letter, supra note 4. See also Letter 
from David Certner, Federal Affairs, AARP, to Jonathan G. Katz, 
Secretary, SEC (Mar. 12, 2004), File No. S7-03-04 (``Certner 
Letter'') (``By requiring that three-quarters of board members--
including the chairman--be independent, the proposed rule helps to 
ensure that this oversight function will be controlled by 
individuals whose sole obligation is to ensure that shareholders' 
interests are protected'').
---------------------------------------------------------------------------

    A fund board whose independent directors constitute at least 75 
percent of the fund board should strengthen the hand of the independent 
directors when dealing with fund management,\36\ and may assure that 
independent directors maintain control of the board \37\ and its 
agenda.\38\
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    \36\ As we noted when we proposed these amendments, section 
15(f) of the Act, which provides a safe harbor for the sale of an 
advisory business, requires that fund directors who are independent 
of the adviser constitute at least 75 percent of the fund board for 
three years following the assignment of the advisory contract, and 
that no unfair burden be imposed on the fund. 15 U.S.C. 80a-15(f). 
This increased independence of the board was designed to help 
protect the fund from receiving unfair treatment in circumstances 
involving potential conflicts of interest. See S. Rep. No. 75, 94th 
Cong., 1st Sess. 140 (1975) (``These conditions are designed to 
prevent any unfair burden from being imposed on the investment 
company in connection with such a transaction.''). Because the 
Exemptive Rules permit certain transactions that involve potential 
harm to the fund as a result of conflicts of interest, see supra 
notes 10-11 and accompanying text, we anticipate that a 75 percent 
level of independence will similarly equip fund boards to monitor 
and guard against such harms in connection with the activities of 
the fund undertaken in reliance on those Rules.
    \37\ As one commenter noted, a 75 percent level can be more 
effective than a simple majority in ensuring control of the board by 
independent directors if one or more independent directors are 
absent from a board meeting. See Consumer Federation Letter, supra 
note 4 (``[I]f one or more of the independent directors has a 
mediocre attendance record, the majority [of independent directors] 
may in reality function as a minority.'').
    \38\ Control of the board and its agenda by fund management can 
hinder the ability of the directors to oversee the fund's operations 
under the Exemptive Rules. See, e.g., Repurchase Offers by Closed-
End Management Investment Companies, Investment Company Act Release 
No. 19399 (Apr. 7, 1993) [58 FR 19330 (Apr. 14, 1993)] (noting the 
need for active independent director involvement in the oversight of 
rule 23c-3 because the determination of the amount of each 
repurchase offer presents a potential conflict of interest between 
the investment adviser and shareholders: the investment adviser may 
be interested in making a small repurchase offer in order to retain 
maximum assets under management).
---------------------------------------------------------------------------

    The final rule differs from the proposed rule in one respect. The 
proposed rule would have required simply that any fund relying on an 
Exemptive Rule have a board of directors with at least 75 percent 
independent directors. Some commenters from funds with small boards 
expressed concern about the costs of hiring new directors to meet this 
requirement. A 75 percent standard would require a three-person board 
with two independent directors to either replace its inside director 
with an independent director, hire an additional independent director 
to satisfy the new standard, or seek the resignation of the interested 
director. We are sensitive to the costs of our rules and therefore have 
modified the final rule to include an exception for boards with three 
directors. The final rule provides that a board with three directors 
satisfies the independence requirement if all but one of the directors 
(i.e., two directors) are independent.\39\
---------------------------------------------------------------------------

    \39\ See rule 0-1(a)(7)(i).
---------------------------------------------------------------------------

B. Independent Chairman of the Board

    We are adopting an amendment to require that any fund that relies 
on an Exemptive Rule have a chairman of its board who is an independent 
director.\40\ We received approximately 152 comments on this amendment, 
which was the most controversial among the fund governance standards we 
proposed. The comments were divided between those supporting and those 
opposing the amendment. Those supporting the amendment,\41\ including 
investors and investor groups, stated that an independent chairman 
would provide many benefits, including better protection of fund 
shareholders.\42\
---------------------------------------------------------------------------

    \40\ See rule 0-1(a)(7)(iv).
    \41\ See, e.g., Certner Letter, supra note 35. See also Letter 
from James J. McMonagle to William H. Donaldson, Chairman, SEC (Jan. 
14, 2004), File No. S7-03-04 (``McMonagle Letter''); Letter from 
Patricia Rizzolo to Jonathan G. Katz, Secretary, SEC (Feb. 24, 
2004), File No. S7-03-04.
    \42\ See supra note 11.
---------------------------------------------------------------------------

    A fund board's primary responsibility is to protect the interest of 
the fund and its shareholders, which may be adversely affected by the 
substantial ongoing conflicts of interest of the fund management 
company.\43\ The consequences of these conflicts are well demonstrated 
by many of our ongoing enforcement actions involving late trading, 
inappropriate market timing and misuse of nonpublic portfolio 
information.\44\ We believe that a fund board is in a better position 
to protect the interests of the fund, and to fulfill the board's 
obligations under the Act and the Exemptive Rules,\45\ when its 
chairman does not have the conflicts of interest inherent in the role 
of an executive of the fund adviser.\46\
---------------------------------------------------------------------------

    \43\ See 2001 Adopting Release, supra note 2. See also S. Rep. 
No. 76-1775, at 6-7 (1940); S. Rep. No. 91-184, at 5-6 (1969); 
Division of Investment Management, Protecting Investors: A Half 
Century of Investment Company Regulation 255-263 (1992).
    \44\ See supra note 4.
    \45\ See supra note 9 (describing the responsibilities of fund 
directors and independent directors to oversee fund activities 
pursuant to the Exemptive Rules).
    \46\ A number of our Exemptive Rules require the board to 
address the fund's activities in circumstances involving these 
conflicts of interest. See, e.g., rule 12b-1(b)(2) (requiring the 
fund board to approve the plan for using fund assets to pay for the 
distribution of fund shares); Bearing of Distribution Expenses by 
Mutual Funds, Investment Company Act Release No. 11414 (Oct. 28, 
1980) [45 FR 73898 (Nov. 7, 1980)] (noting the conflicts of interest 
between the fund and its adviser when fund assets are used for 
distribution of shares); rule 17a-8 (requiring directors to request 
and evaluate information reasonably necessary to determine that the 
merger of the fund with an affiliated fund is in the fund's best 
interests, and to determine that the interests of fund shareholders 
will not be diluted as a result of the merger); Investment Company 
Mergers, Investment Company Act Release No. 25666 (July 18, 2002) 
[67 FR 48511 (July 24, 2002)] (discussing some of the factors that 
directors should consider in approving affiliated fund mergers); 
rule 15a-4 (permitting temporary contract between fund and 
investment adviser without shareholder approval); Temporary 
Exemption for Certain Investment Advisers, Investment Company Act 
Release No. 23325 (July 22, 1998) [63 FR 40231 (July 28, 1998)] at 
text accompanying notes 24-25 (noting the responsibility of the 
board under rule 15a-4 to determine that the scope and quality of 
services under the temporary contract are at least equivalent to 
those under the previous contract, and noting that the board is 
empowered to terminate the temporary contract upon short notice, in 
order to allow it to act quickly if advisory services decline in 
quality).

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

[[Page 46383]]

    The board chairman can play an important role in setting the agenda 
of the board, and in establishing a boardroom culture that can foster 
the type of meaningful dialogue between fund management and independent 
directors that is critical for healthy fund governance. The chairman 
can play an important role in providing a check on the adviser, in 
negotiating the best deal for shareholders when considering the 
advisory contract, and in providing leadership to the board that 
focuses on the long-term interests of investors.\47\ We believe that a 
fund chairman is in the best position to fulfill these responsibilities 
when his loyalty is not divided between the fund and its investment 
adviser.
---------------------------------------------------------------------------

    \47\ See Letter from Anne J. Mills, Trustee, to Jonathan G. 
Katz, Secretary, SEC (Feb. 2, 2004), File No. S7-03-04 (stating that 
while appointing a lead independent director has improved 
involvement of independent trustees, ``it is still difficult to 
influence the Board meeting agenda to assure full discussion of the 
more important items. Having an independent chair will significantly 
change the dynamics of the board meetings.''); Letter from Ashok N. 
Bakhru, Chairman of the Board and Independent Trustee, Goldman Sachs 
Trust and Goldman Sachs Variable Insurance Trust, to Jonathan G. 
Katz, Secretary, SEC (Mar. 9, 2004), File No. S7-03-04 (supporting 
the amendment and adding that ``It has been our experience that the 
chairman can provide an important and meaningful role in the 
preparation of board agenda and in fostering the dialogue between 
fund management and the independent directors on fund-related 
matters.'').
---------------------------------------------------------------------------

    Those opposing the amendment, including some independent directors, 
argued that it would deprive the independent directors of the ability 
to choose for themselves the most qualified and capable candidate to 
serve as chairman and thereby undermine the directors' ability to carry 
out their responsibilities.\48\ To be clear, the amendments we are 
adopting today do not prevent the independent directors from choosing 
the most qualified and capable candidate. That candidate, however, 
cannot serve two masters.
---------------------------------------------------------------------------

    \48\ See Letter from Investment Company Institute to Jonathan G. 
Katz, Secretary, SEC (March 10, 2004), File No. S7-03-04; Murray 
Letter, supra note 34.
---------------------------------------------------------------------------

    Some asserted that independent directors would not have sufficient 
knowledge or be as well prepared to lead the board through its many 
tasks, unless the board chairman is affiliated with the adviser and 
therefore is able to obtain needed information from the advisory 
firm.\49\ They similarly argued that the independent chairman might be 
drawn into the day-to-day management of the fund. As noted above, we 
believe a board chairman typically plays an important role in setting 
the agenda of the board and determining what information is provided to 
the board. An independent chairman will undoubtedly consult with 
management in carrying out its functions, as well as in leading the 
board through its various tasks. But the final decisions in setting the 
agenda will be made by someone independent of management.\50\ Moreover, 
the chairman is in a unique position to set the tone of meetings, and 
to encourage open dialogue and healthy skepticism. We believe an 
independent chairman is better equipped to serve this role. Finally, 
representatives of management would still be responsible for the day-
to-day operations of the fund, would continue to be able to serve as 
fund directors and would have access to information from the adviser. 
We do not believe that this amendment will deprive the board of 
management's knowledge and judgment.
---------------------------------------------------------------------------

    \49\ See Letter from F. Pierce Linaweaver, Chairman of the 
Committee of Independent Directors, T. Rowe Price Mutual Funds, to 
Jonathan G. Katz, Secretary, SEC (Feb. 25, 2004), File No. S7-03-04.
    \50\ See Letter from Chairman Michael G. Oxley, House Committee 
on Financial Services, to William H. Donaldson, Chairman, SEC (May 
20, 2004), File No. S7-03-04 (``I believe the Commission's 
independent chairman proposal would eradicate the self-dealing by 
interested, management-affiliated chairmen and its harmful effects 
on mutual fund shareholders.'') (``Chairman Oxley Letter'').
---------------------------------------------------------------------------

    If the board is to provide effective oversight of the management 
company, there may be times when it must be prepared to say ``no'' to 
the manager's chief executive officer.\51\ We do not mean to suggest 
that the relationship between the board and the management company need 
be adversarial. Indeed, we believe that a crucial challenge to every 
fund board involves establishing an appropriate balance between 
cooperation with the management company and oversight of the management 
company. Our primary concern, and the one that has led us to adopt this 
amendment, is that too often the proper balance has not been achieved, 
particularly where an executive of the adviser has exerted a dominant 
influence over the board. While having an independent chairman should 
not disadvantage a board that is properly balanced, it may 
significantly benefit one that is not.
---------------------------------------------------------------------------

    \51\ We received a particularly insightful comment letter from a 
fund independent director who stated that his board's appointment of 
an independent chairman was instrumental in causing the board to 
switch fund advisers. See McMonagle Letter, supra note 41 (stating 
that the mutual fund of which the author was an independent director 
changed the advisory contract from one adviser to another, and 
observing that ``[i]f the Chairman of the [mutual fund's board] had 
not been independent, I am satisfied that we would not have moved 
the advisory contract.'') (emphasis omitted). See also Letter from 
David S. Ruder, Chairman, and Allan S. Mostoff, President and 
Treasurer, Mutual Fund Directors Forum, to Jonathan G. Katz, 
Secretary, SEC (May 14, 2004), File No. S7-03-04 (stating that the 
Mutual Fund Directors Forum will recommend as a best practice that 
fund boards be chaired by an independent director, because that 
approach would enhance the power and authority of independent 
directors and eliminate the chairman's conflicts of interest).
---------------------------------------------------------------------------

    Some have argued that the Commission needs to demonstrate 
conclusively that there is a link between having an independent 
chairman and increased performance or decreased fund expenses.\52\ The 
Commission considered its own and its staff's experience, the many 
comments received, and other evidence, in addition to the limited and 
conflicting empirical evidence. From this, we

[[Page 46384]]

believe that having independent chairmen can provide benefits and serve 
other purposes apart from achieving high performance of the fund. In 
this regard, corporate governance experts have pointed more generally 
to the value that an independent chairman brings to a corporate board 
of directors.\53\
---------------------------------------------------------------------------

    \52\ We are not aware of any conclusive research that 
demonstrates that the hiring of an independent chairman will improve 
fund performance or reduce expenses, or the reverse. Commenters did 
not refer us to any pre-existing studies that spoke to this issue. 
One commenter submitted a study that it commissioned in response to 
the proposal, that sought to ascertain a correlation between 
independent chairmen and the performance and expenses of funds. With 
regard to performance, the study found a correlation between funds 
with management chairmen and higher performance. The study noted, 
however, that this correlation may be due to ``other important 
differences [than independence of the chairmen] that may have 
impacted performance results,'' such as the prevalence of 
independent chairmen among bank-sponsored fund groups. With regard 
to fund expenses, the study found, depending on the method of 
calculation, lower (but not statistically significant) expenses 
associated with independent chairmen funds, or higher expenses for 
those types of funds. The study stated that the expense analysis 
comparisons were less clear than with the performance results, and 
``differ considerably depending on what expense measure is used.'' 
See Geoffrey H. Bobroff and Thomas H. Mack, Assessing the 
Significance of Mutual Fund Board Independent Chairs, A Study for 
Fidelity Investments (Mar. 10, 2004) (attached to Letter from Eric 
D. Roiter, Senior Vice President and General Counsel, Fidelity 
Management & Research Company to Jonathan G. Katz, Secretary, SEC 
(Mar. 18, 2004), File No. S7-03-04)). On the other hand, some 
commenters viewed the data differently and concluded that 
``[i]ndependently-chaired funds did only slightly better in terms of 
returns, but at lower cost * * *. Even accepted at face value, 
Fidelity's data constitute muddy and unpersuasive evidence for 
continuing to allow senior management company officials to sit in 
the fund chairman's chair.'' Remarks by John C. Bogle, Founder and 
Former CEO, The Vanguard Group, before the Institutional Investor 
Magazine Mutual Fund Regulation and Compliance Conference (May 5, 
2004), File No. S7-03-04. See also Letter from John A. Hill, 
Chairman, The Putnam Funds, to William H. Donaldson, Chairman, SEC 
(May 12, 2004), File No. S7-03-04.
    \53\ See Ira M. Millstein and Paul W. MacAvoy, Proposals for 
Reform of Corporate Governance, in The Recurrent Crisis in Corporate 
Governance 95, 119 (2003) (``The first important initiative is for 
the [corporate] board * * * to develop an identified independent 
leadership, by separating the roles of chairman of the board and CEO 
and appointing an independent director as chairman. Independent 
leadership is critical to positioning the board as an objective body 
distinct from management. * * * The board cannot function without 
leadership separate from the management it is supposed to monitor. 
On behalf of the shareholders, the board must be enabled to obtain 
the information necessary to monitor * * * the performance of 
management * * *.''). See also Consumer Federation Letter, supra 
note 4 (``In light of the fact that the board's chief responsibility 
is to police conflicts of interest and ensure that shareholders' 
interests are protected, it is also symbolically important that the 
chairman be independent. Putting a representative of the investment 
adviser in this position creates the appearance, and inevitably in 
some cases, the reality, that the fox is guarding the henhouse.'').
---------------------------------------------------------------------------

    We harbor no illusions that the designation of an independent 
chairman will address all of the compliance and other problems 
confronting funds.\54\ The rules we are adopting today are part of a 
larger package of regulatory reforms designed both to prevent the 
compliance failures of yesterday and to strengthen a fund board's 
ability to deal with compliance challenges of the future. A key element 
of that larger package is our rule requiring each fund to designate a 
chief compliance officer who reports directly to the fund board.\55\ 
With the information about fund compliance matters now required by our 
rule 38a-1, and the information about advisory contract renewal 
required by section 15(c) of the Act, fund boards are better able to 
fulfill their responsibilities.\56\
---------------------------------------------------------------------------

    \54\ One commenter, however, provided statistics indicating that 
a large majority of mutual fund families implicated in recent 
scandals have had management-affiliated chairmen at some point 
during the alleged or admitted violations. Chairman Oxley Letter, 
supra note 50.
    \55\ See Compliance Programs, supra note 7.
    \56\ Section 15 requires that fund directors, including a 
majority of independent directors, approve the fund's advisory 
contract each year. The directors must approve the advisory contract 
initially, and annually thereafter if it continues in effect for 
more than two years. Section 15(a) and (c) of the Act [15 U.S.C. 
80a-15(a) and (c)]. It also requires that the directors first obtain 
from the adviser the information reasonably necessary to evaluate 
the contract so that directors would have adequate information upon 
which to base their decision about the advisory contract generally 
and the advisory fee in particular. Section 15(c) of the Act [15 
U.S.C. 80a-15(c)].
---------------------------------------------------------------------------

    We carefully considered alternatives suggested to us by commenters, 
including designation of a lead independent director and increased 
reliance on board committees chaired by independent directors. A lead 
independent director could provide useful leadership to the independent 
directors when dealing with the board chairman,\57\ and independent 
committee chairmen may provide important services to the fund. Neither 
of these arrangements, however, would create a position that is likely 
to be filled by a person with sufficient stature within the fund 
complex to serve as an effective counterweight to a fund chairman who 
may also be the chief executive officer of the management company.\58\ 
Further, as commenters pointed out, ``[a]ppointing a lead director does 
nothing to ensure that independent directors control the agenda, 
information requests, and terms of board debate.'' \59\ Commenters 
recommended a variety of other alternatives, including having the audit 
committee chair set the agenda. We believe that the board's agenda 
should be under the control of an independent director.
---------------------------------------------------------------------------

    \57\ See ICI Advisory Group Report, supra note 24, at 25 
(recommending that independent directors designate one or more lead 
independent directors).
    \58\ See Letter from Fergus Reid III to William H. Donaldson, 
Chairman, SEC (May 18, 2004), File No. S7-03-04 (``The Lead Director 
concept is flawed--A lead director is immediately at a disadvantage 
when dealing with a strong interested chairman. To assert him or 
herself, the lead director must oppose or go around the wishes of an 
interested chairman. This creates tension and ill will and is rarely 
politically expedient''). The by-laws of some funds may state that 
the board chairman is an officer of the fund. Under the amendments 
we are adopting today, a fund in those circumstances that relies on 
an Exemptive Rule would need to amend its by-laws, because an 
officer of the fund is an interested person of the fund. See section 
2(a)(19)(A)(i) of the Act [15 U.S.C. 80a-2(a)(19)(A)(i)] (definition 
of ``interested person''). Funds whose by-laws do not contain such a 
requirement also may wish to amend their by-laws to require that the 
chairman be an independent director, as a good corporate practice, 
to help ensure that a fund relying upon any Exemptive Rule satisfies 
these fund governance standards. In either case, funds would have to 
disclose the appointment of any new chairman and the changes to by-
laws in their filings with the Commission.
    \59\ See Consumer Federation Letter, supra note 4.
---------------------------------------------------------------------------

    Our action today should not be construed as diminishing the value 
that executives of the adviser, including the adviser's chief executive 
officer, bring to the fund boardroom. We fully expect that these 
executives will continue to serve on fund boards, although not in the 
capacity of chairman, and thus will have every opportunity to engage 
the board on issues important to the fund investors as well as the 
management company.\60\ Similarly, to the extent that some executives 
of the adviser leave fund boards in order to meet the supermajority 
requirement, we expect that they will continue to participate, in 
appropriate circumstances, in board and board committee deliberations.
---------------------------------------------------------------------------

    \60\ Rule 0-1(a)(7)(iv) provides that a fund may rely on an 
Exemptive Rule only if an independent director serves as chairman of 
the board of directors of the fund, presides over meetings of the 
board of directors and has substantially the same responsibilities 
as would a typical chairman of a board of directors. In response to 
the amendments we are adopting today, some funds might be tempted to 
circumscribe the role of the independent chairman to preserve the 
current role of an interested board chairman. We caution against 
such action, which may result in the loss of multiple exemptions 
from provisions of the Act and multiple violations of the Act. For 
example, a fund could not designate an interested director to 
preside over meetings or set meeting agendas, or name an interested 
director as a ``co-chairman'' of the board. We would not, however, 
consider temporary performance of a chairman's duties (e.g., due to 
a chairman's illness or inability to attend) by an interested 
director (e.g., by a vice chairman) as a failure to meet the 
requirements of rule 0-1(a)(7)(iv).
---------------------------------------------------------------------------

C. Annual Self-Assessment

    We are also amending the Exemptive Rules to require fund directors 
to evaluate, at least once annually, the performance of the fund board 
and its committees.\61\ This evaluation must include a consideration of 
the effectiveness of the committee structure of the fund board \62\ and 
the number of funds on whose boards each director serves. Most 
commenters supported this amendment, and we are adopting it as 
proposed.
---------------------------------------------------------------------------

    \61\ See rule 0-1(a)(7)(v).
    \62\ The requirement is designed to focus the board's attention 
on the need to create, consolidate or revise the various board 
committees, such as the audit, nominating or pricing committees, and 
to facilitate a critical assessment of the effectiveness of current 
board committees.
---------------------------------------------------------------------------

    This annual self-assessment requirement is intended to improve fund 
performance by strengthening directors' understanding of their role and 
fostering better communications and greater cohesiveness. Moreover, the 
requirement should help fund boards to identify potential weaknesses 
and deficiencies in the board's performance. The amendment does not 
require that the board's self-assessment be in writing. Nevertheless, 
we would expect that the minutes of the board would reflect the 
substance of the matters discussed during the board's annual self-
assessment.\63\
---------------------------------------------------------------------------

    \63\ See Proposing Release, supra note 2, at n.37.
---------------------------------------------------------------------------

D. Separate Sessions

    We are also amending the Exemptive Rules to require independent 
directors to meet at least once quarterly in a separate session at 
which no directors who are interested persons of the fund are 
present.\64\ Commenters supported

[[Page 46385]]

this provision, which is designed to give independent directors the 
opportunity for a frank and candid discussion among themselves 
regarding the management of the fund, including its strengths and 
weaknesses.\65\ The rule does not specify the matters that should be 
discussed by the independent directors at the separate executive 
sessions, although we expect that the independent directors would use 
this forum to discuss, among other things, their views on the 
performance of the fund adviser and other service providers.
---------------------------------------------------------------------------

    \64\ See rule 0-1(a)(7)(vi).
    \65\ We anticipate that the frank and candid discussion among 
the independent directors also would cover the fund's activities 
pursuant to the Exemptive Rules. The independent directors, for 
example, could discuss the use of fund assets to pay for the 
distribution of fund shares under rule 12b-1 and the fund's 12b-1 
plan adopted by the board. See supra note 46.
---------------------------------------------------------------------------

E. Independent Director Staff

    The final amendment to the Exemptive Rules we are adopting today 
requires funds to explicitly authorize the independent directors to 
hire employees and to retain advisers and experts necessary to carry 
out their duties.\66\ Commenters supported this amendment, which is 
designed to enable independent directors to hire employees and others 
who will help them deal with matters beyond their expertise. We expect 
that the amendment should help independent directors address complex 
matters and provide them with an understanding of the practices of 
other mutual funds.\67\ Fund shareholders should receive substantial 
benefits because we expect that these requirements will help to ensure 
that independent directors are better able to fulfill their role of 
representing shareholder interests.\68\
---------------------------------------------------------------------------

    \66\ See rule 0-1(a)(7)(vii). The amendment does not require 
independent directors to hire employees or retain advisers or 
experts.
    \67\ Some of the Exemptive Rules, for example, require that fund 
directors oversee complex transactions. See, e.g., rule 10f-3 
(permitting funds to purchase securities in a primary offering when 
an affiliated broker-dealer is a member of the underwriting 
syndicate if the fund's board, including a majority of its 
independent directors, (i) approves procedures regulating purchases 
of these securities and (ii) determines at least quarterly that the 
purchases complied with the board-approved procedures). The rules 
also require directors of funds relying on the rules to exercise 
vigilance in protecting funds and their investors. See, e.g., 
Exemption for the Acquisition of Securities During the Existence of 
an Underwriting or Selling Syndicate, Investment Company Act Release 
No. 22775 (July 31, 1997) [62 FR 42401 (Aug. 7, 1997)], at n.52 and 
accompanying text (the fund's board should be ``vigilant'' not only 
in reviewing the fund's compliance with the procedures required by 
rule 10f-3, but also ``in conducting any additional reviews that it 
determines are needed to protect the interests of investors''). 
Directors may need to hire staff to help conduct these reviews.
    \68\ One of the most useful advisers independent directors 
should consider engaging is their own counsel. Although we are not 
requiring independent directors to have their own counsel, we agree 
with the American Bar Association's view that ``[t]he complexities 
of the Investment Company Act, the nature of the separate 
responsibilities of independent directors and the inherent conflicts 
of interest between a mutual fund and its managers effectively 
require that independent directors seek the advice of counsel in 
understanding and discharging their special responsibilities.'' 
American Bar Association, Report of the Task Force on Independent 
Director Counsel, Subcommittee of Investment Companies and 
Investment Advisers, Committee on Federal Regulation of Securities, 
Section of Business Law: Counsel to the Independent Directors of 
Registered Investment Companies at 3 (Sept. 8, 2000). See generally 
James D. Cox, Symposium: Lessons from Enron, How Did Corporate and 
Securities Law Fail? Managing and Monitoring Conflicts of Interests: 
Empowering the Outside Directors with Independent Counsel, 48 Vill. 
L. Rev. 1077 (2003). If independent directors do hire their own 
counsel, and their fund relies on any of the Exemptive Rules, such 
counsel must be an ``independent counsel.'' Rule 0-1(a)(7)(iii).
---------------------------------------------------------------------------

F. Recordkeeping for Approval of Advisory Contracts

    Finally, we are amending rule 31a-2, the fund recordkeeping rule, 
to require that funds retain copies of the written materials that 
directors consider in approving an advisory contract under section 15 
of the Investment Company Act.\69\ Commenters supported this amendment, 
and we are adopting it as proposed.\70\ The amendment requires funds to 
retain the materials for at least six years, the first two years in an 
easily accessible place.
---------------------------------------------------------------------------

    \69\ See rule 31a-2(a)(6). See also supra note and accompanying 
text.
    \70\ We did not receive specific comment on the detailed 
questions on which we sought comment pursuant to section 31(a)(2) of 
the Act [15 U.S.C. 80a-30(a)(2)], i.e., whether there are feasible 
alternatives to the proposed amendment that would minimize the 
recordkeeping burdens, the necessity of these records in 
facilitating the examinations carried out by our staff, the costs of 
maintaining the required records, and any effects that the proposed 
recordkeeping requirements would have on firms' internal compliance 
policies and procedures. We have nevertheless considered those 
issues in the course of adopting this recordkeeping rule amendment. 
We do not believe that there are any feasible alternatives to the 
amendment that would minimize recordkeeping burdens, and, as 
discussed above, the records are necessary to facilitate the 
examinations carried out by our staff. Finally, we are not aware of 
any adverse effects that the recordkeeping requirement will have on 
the nature of firms' internal compliance policies and procedures. In 
fact, we anticipate that the recordkeeping requirement will 
facilitate fund internal compliance programs because the fund's 
compliance staff will be able to monitor the information on which 
directors rely in approving the fund's advisory contract.
---------------------------------------------------------------------------

    The recordkeeping amendment is designed to improve the 
documentation of a fund board's basis for approving an advisory 
contract, which would assist our examination staff in determining 
whether fund directors are fulfilling their fiduciary duties when 
approving advisory contracts. The amendment underscores the importance 
of the information requests that precede the directors' consideration 
of the advisory contract. Further, it may encourage independent 
directors to request more information, and this information may enable 
them to obtain more favorable terms in advisory contracts.

IV. Effective Date; Compliance Date

    The amendments to the Exemptive Rules will become effective on 
September 7, 2004.
    After January 15, 2006: (i) persons may rely upon any of the 
Exemptive Rules (rules 10f-3, 12b-1, 15a-4(b)(2), 17a-7, 17a-8, 17d-
1(d)(7), 17e-1, 17g-1(j), 18f-3, and 23c-3) only if they comply with 
all of the ``fund governance standards'' as defined in rule 0-1(a)(7); 
\71\ and (ii) funds must begin to comply with the recordkeeping 
requirements of amended rule 31a-2.
---------------------------------------------------------------------------

    \71\ After the effective date but before the compliance date of 
the amendments, a person that relies on an Exemptive Rule must 
continue to meet the fund governance requirements of the Exemptive 
Rules we adopted in 2001 concerning a majority of independent 
directors, independent director self-selection and self-nomination, 
and independent legal counsel. See Proposing Release, supra note 2.
---------------------------------------------------------------------------

V. Paperwork Reduction Act

    As discussed in the Proposing Release, the amendment to rule 31a-2 
contains a ``collection of information'' requirement within the meaning 
of the Paperwork Reduction Act of 1995 \72\ because the amendment to 
rule 31a-2 will require funds to retain copies of the written materials 
that boards consider in approving advisory contracts under section 
15(c) of the Investment Company Act. Funds have to retain these 
materials for at least six years, the first two years in an easily 
accessible place for our examiners. This collection of information is 
necessary for our staff to use in its examination and oversight 
program. Responses provided in the context of the Commission's 
examination and oversight program are generally kept confidential. The 
collection of information requirement is mandatory and is in the form 
of an amendment to a currently approved collection of information 
requirement, the title of which is ``Rule 31a-2, `Records to be 
preserved by registered investment companies, certain majority-owned 
subsidiaries thereof, and other persons having transactions with 
registered investment companies.' ;'' An agency may not conduct or 
sponsor, and a person is not required to respond to, a collection of 
information unless it displays a currently valid control number. The 
approved collection of information associated with rule 31a-2 to be 
revised by the amendments

[[Page 46386]]

displays control number 3235-0179. The Commission submitted the 
collection to the Office of Management and Budget (``OMB'') for review 
in accordance with 44 U.S.C. 3507(d) and 5 CFR 1320.11. OMB has 
approved the collection of information under control number 3235-0179 
(expiring on July 31, 2007).
---------------------------------------------------------------------------

    \72\ 44 U.S.C. 3501 to 3520.
---------------------------------------------------------------------------

    The amendment to the collection of information requirement for rule 
31a-2 is necessary for our compliance examiners to determine whether 
fund boards have met the requirements of section 15 of the Investment 
Company Act when approving investment advisory contracts. Our 
compliance examiners will review these materials to gauge a fund 
board's fulfillment of the requirements of section 15 of the Act.
    As discussed above, we are adopting the amendment to rule 31a-2 and 
this collection of information requirement as proposed. In the 
Proposing Release, our staff estimated that each fund will spend a 
total of 0.5 hours annually and a total of $9.46 for clerical time to 
comply with this amendment.\73\ In the Proposing Release, we solicited 
comments on the accuracy of these estimates. None of the comments 
received specifically addressed our estimates of the costs associated 
with the collection of information requirement.\74\ Our staff continues 
to estimate that each fund will spend a total of 0.5 hours annually and 
a total of $9.46 for clerical time to comply with this amendment. 
Because of the increase in the number of registered funds to 5,132 
funds, however, our staff estimates that the total hour burden of the 
collection of information requirement for all funds is 2,566 hours and 
a total of $48,548.72 annually to comply with this amendment.
---------------------------------------------------------------------------

    \73\ In the Proposing Release, we estimated that 5,124 funds 
would incur costs under this requirement. To calculate these costs, 
our staff used $18.92 per hour as the average cost of clerical time. 
We now estimate that there are 5,132 registered funds that may incur 
costs under this amendment.
    \74\ See Letter from James H. Bodurtha, Chair, Directors' 
Committee, Investment Company Institute, to Jonathan G. Katz, 
Secretary, SEC (Mar. 10, 2004), File No. S7-03-04 (stating that ``We 
believe that the retention costs should be minimal and should not be 
a consideration in the implementation of this proposal. Requiring 
retention, in our opinion, will not change practices in terms of the 
volume of information requested by directors in connection with 
their review of the advisory contract.'') (``ICI Letter'').
---------------------------------------------------------------------------

VI. Cost-Benefit Analysis

    We are sensitive to the costs and benefits imposed by our rules. As 
discussed in section III above, these amendments require that funds 
relying on any of the Exemptive Rules adopt certain governance 
practices that are designed to enhance the independence and 
effectiveness of fund boards. We also are adopting amendments to 
require that funds maintain materials considered by a fund board when 
approving an advisory contract. In the Proposing Release, we identified 
probable costs and benefits of each of these proposed amendments that 
we are adopting today, and we requested public comment on our analysis 
of the costs and benefits of each of these amendments.
    We expect that funds and fund shareholders are likely to benefit 
from the amendments because they are designed to strengthen the role of 
independent directors so that fund boards can more effectively manage 
conflicts of interest, monitor service providers, and protect the 
interests of fund shareholders. Boards that satisfy these conditions 
should be more effective at exerting an independent influence over fund 
management and other fund service providers because the fund 
independent directors are more likely to be primarily loyal to the fund 
shareholders rather than the fund adviser.

A. Benefits

    The amendments seek to promote strong fund boards that effectively 
perform their oversight role. By increasing the independence of fund 
boards, the amendments are designed to improve the quality of the 
oversight of the process for the benefit of fund investors. Vigilant 
and informed oversight by a strong, effective and independent fund 
board may help to prevent problems such as late trading and market 
timing. These benefits may increase investor confidence in fund 
management. While these benefits are not easily quantifiable in terms 
of dollars, we believe they are real, and that the amendments will 
strengthen the hand of independent directors to the advantage of 
shareholders.\75\ A fund board whose independent directors constitute 
at least 75 percent of the fund board should strengthen the hand of the 
independent directors when dealing with fund management, and may assure 
that independent directors maintain control of the board and its 
agenda.\76\
---------------------------------------------------------------------------

    \75\ For a more complete discussion of the benefits to 
shareholders and boards in overseeing a fund's activities under the 
Exemptive Rules, see supra Section III.
    \76\ The majority of commenters generally agreed that increasing 
the independence of fund boards was beneficial to fund shareholders. 
Some commenters recommended that the percentage of independent 
directors be greater than 75 percent or that the conditions for 
being an independent director be stricter.
---------------------------------------------------------------------------

    We expect that requiring fund boards to be chaired by an 
independent director will provide similar benefits to increasing the 
percentage of independent directors. Because the chairman of a fund 
board can have a substantial influence on the fund board agenda and on 
the fund boardroom's culture, we expect that this requirement will 
advance meaningful dialogue between the fund adviser and independent 
directors and will support the role of the independent directors in 
overseeing the fund adviser. Further, we expect that the opportunity 
for frank and candid discussions among independent directors that will 
result from the rule amendments will increase the effectiveness of the 
independent directors.\77\
---------------------------------------------------------------------------

    \77\ Commenters were divided as to the relative benefits of this 
requirement. See supra text following note 40.
---------------------------------------------------------------------------

    The amendment to require an annual self-assessment of the 
effectiveness of the board and its committees is intended to improve 
fund performance by strengthening directors' understanding of their 
role and fostering better communications and greater cohesiveness. 
Moreover, the requirement for fund boards to perform an annual self-
assessment should help fund boards to identify potential weaknesses and 
deficiencies. All but one of the comments received expressed support 
for a requirement that boards perform a self-assessment.
    We expect that the requirement that independent directors must meet 
at least once quarterly in separate sessions, without the presence of 
directors who are interested persons, likewise will improve fund 
performance by strengthening the role of independent directors and 
fostering better communications and greater cohesiveness among the 
independent directors. Commenters were supportive of this proposal.
    We expect that the amendment to require funds to explicitly 
authorize independent directors to hire employees and to retain 
advisers and experts will help independent directors address complex 
matters and provide them with an understanding of the practices of 
other mutual funds. Fund shareholders should receive substantial 
benefits because we expect that these requirements will help to ensure 
that independent directors are better able to fulfill their role of 
representing shareholder interests. Most commenters expressed support 
for this amendment. These commenters agreed that fund boards already 
have the authority to hire

[[Page 46387]]

employees, but that this is a useful amendment.
    Finally, the recordkeeping amendment is designed to improve the 
documentation of a fund board's basis for approving an advisory 
contract, which will assist our examination staff in determining 
whether fund directors are fulfilling their fiduciary duties when 
approving advisory contracts. The amendment to rule 31a-2 underscores 
the importance of the information requests that precede the directors' 
consideration of the advisory contract. Further, it may encourage 
independent directors to request more information, and this information 
may enable them to obtain more favorable terms in advisory contracts. 
Comments generally were supportive of this amendment.

B. Costs

    The amendments will impose additional costs on funds that rely on 
an Exemptive Rule by requiring them to satisfy the fund governance 
standards in rule 0-1(a)(7). The amendments will require that 
independent directors constitute at least 75 percent of the fund board 
or, if the fund board has only three directors, will require that all 
but one director be independent.\78\ Therefore, a fund that does not 
already meet this standard may: (i) Decrease the size of its board and 
allow some interested directors to resign; (ii) maintain the current 
size of its board and replace some interested directors with 
independent directors; or (iii) increase the size of its board and 
elect new independent directors. If a fund holds a shareholder 
election, it will incur costs to prepare proxy statements and hold the 
shareholder meeting. A fund also will incur costs of finding qualified 
candidates and compensating those new independent directors.\79\ As 
noted in the Proposing Release, our staff has no reliable basis for 
determining how funds would choose to satisfy this requirement and 
therefore it is difficult to determine the costs associated with 
electing independent directors.\80\ As discussed in section III above, 
under the proposed amendments, boards that have three directors, unlike 
fund boards that have four or more directors, would have to be composed 
of all independent directors in order to meet the 75 percent 
requirement or, alternatively, would incur costs to increase their 
board size to four directors. In response to concerns about the effect 
of the requirement on boards with only three directors, the exception 
to the 75 percent requirement we are adopting permits boards with three 
directors to have all but one director be independent.
---------------------------------------------------------------------------

    \78\ As indicated in the Proposing Release, our staff estimated 
that nearly sixty percent of all funds currently meet this 
requirement. See Proposing Release, supra note 2 .
    \79\ Under some circumstances a vacancy on the board may be 
filled by the board of directors. See section 16(a) of the 
Investment Company Act [15 U.S.C. 80a-16(a)].
    \80\ With respect to the requirements related to independent 
selection and nomination of other independent directors and 
independent legal counsel, this amendment incorporates the current 
requirements of the Exemptive Rules, and therefore these amendments 
do not impose new costs.
---------------------------------------------------------------------------

    The amendments also require: (i) An independent director to be 
chairman of the board; (ii) directors to perform an evaluation of the 
board and its committees, at least once annually; (iii) independent 
directors to meet in an executive session at which no director who is 
an interested person of the fund is present, at least once quarterly; 
and (iv) independent directors to be given specific authority to hire 
employees and retain experts. As discussed in the Proposing Release, 
our staff is not aware of any out-of-pocket costs that would result 
from the first three items because these requirements could be 
satisfied at a regularly scheduled board meeting.\81\ A few comments 
expressed concern about costs of requiring separate executive sessions 
at least once quarterly. However, as discussed in the Proposing 
Release, we expect that most funds would choose to satisfy this 
requirement by having directors meet at a breakout session of regularly 
scheduled board meetings, which would impose no additional 
transportation and little or no accommodation costs for the directors. 
Therefore, we expect that the costs of complying with this requirement 
would be minimal. With regard to the fourth item, our staff is not 
aware of any costs associated with hiring employees or retaining 
experts because boards typically have this authority under state law, 
and the rule would not require them to hire employees or retain 
experts.
---------------------------------------------------------------------------

    \81\ There may, however, be indirect costs associated with these 
provisions. An independent chairman, for example, may choose to hire 
staff for assistance in carrying out his or her responsibilities as 
chairman. We have no reliable basis for estimating those costs.
---------------------------------------------------------------------------

    Our staff expects that the amendment to require funds to retain 
copies of materials considered by the board in approving advisory 
contracts would result in some increased recordkeeping costs. Our staff 
anticipates that the increased costs will be limited, however, because 
many if not most funds already maintain the documents that the proposed 
amendment would require them to keep. Even for firms that do not 
already maintain such records, our staff anticipates that the costs of 
the amendment will be limited.\82\ This recordkeeping proposal merely 
requires the retention of documents already prepared. Further, as with 
other records, funds would be able to maintain the required records 
electronically. For purposes of the Paperwork Reduction Act, our staff 
estimated that each fund will spend a total of 0.5 hours of clerical 
time annually, at a total of $9.46, to comply with this proposal. We 
requested comment on the number of funds that already retain these 
materials, and on the costs of retaining such materials. We did not 
receive any comments specifically addressing this issue.\83\
---------------------------------------------------------------------------

    \82\ For purposes of the Paperwork Reduction Act, our staff 
estimates that each fund would spend approximately 0.5 hours 
annually maintaining records of documents reviewed by fund boards 
when approving advisory contracts. See Proposing Release, supra note 
2, at Section IV.
    \83\ See ICI Letter, supra note 74.
---------------------------------------------------------------------------

VII. Final Regulatory Flexibility Analysis

    This Final Regulatory Flexibility Analysis (``FRFA'') has been 
prepared in accordance with 5 U.S.C. 604 relating to the amendments to 
the Exemptive Rules and the Commission's rules on investment company 
governance. An Initial Regulatory Flexibility Analysis (``IRFA'') was 
prepared in accordance with 5 U.S.C. 603 and was published in the 
Proposing Release.\84\
---------------------------------------------------------------------------

    \84\ See Proposing Release, supra note 2, at Section VI.
---------------------------------------------------------------------------

A. Reasons for and Objectives of the Amendments

    As described in Section I of this Release and in the Proposing 
Release, the Investment Company Act relies heavily on fund boards of 
directors to manage conflicts of interest that the fund adviser 
inevitably has with the fund. The reasons for these amendments are that 
the breakdown in fund management and compliance controls evidenced by 
our enforcement cases raises troubling questions about the ability of 
many fund boards, as presently constituted, to effectively oversee the 
management of funds. The objectives of the amendments, which apply to 
funds relying on any of the Exemptive Rules, are to enhance the 
independence and effectiveness of fund boards and to improve their 
ability to protect the interests of the funds and fund shareholders 
they serve and to effectively oversee management of the fund.

[[Page 46388]]

B. Significant Issues Raised by Public Comment

    In the IRFA, we requested comment on any aspect of the IRFA and 
specifically requested comment on the number of small entities that 
would be affected by the proposed amendments, the likely impact of the 
proposal on small entities, and the nature of any impact, and empirical 
data supporting the extent of the impact. We received a few comments on 
the impact on small entities.\85\ Four commenters expressed concern 
about the costs associated with hiring new directors for funds with 
small boards to satisfy the requirement that 75 percent of the board be 
independent. These commenters also stated that the costs associated 
with the amendments would be great for small entities because of the 
costs of retaining independent legal counsel, the cost of paying for 
more directors, the costs of holding separate meetings for independent 
directors, the costs of hiring staff for independent directors and the 
costs of having an independent director serve as chairman.\86\
---------------------------------------------------------------------------

    \85\ These commenters defined small entities as entities with 
assets ranging from assets under $218 million to assets under $100 
million, as opposed to assets under $50 million.
    \86\ These amendments that we proposed and are adopting, 
however, do not require independent directors to retain independent 
legal counsel or to hire staff for independent directors, nor do 
these amendments require funds to increase the size of their boards.
---------------------------------------------------------------------------

C. Small Entities Subject to the Amendments

    A small business or small organization (collectively, ``small 
entity'') for purposes of the Regulatory Flexibility Act is a fund 
that, together with other funds in the same group of related investment 
companies, has net assets of $50 million or less as of the end of its 
most recent fiscal year.\87\ Of approximately 5,132 registered 
investment companies, approximately 233 are small entities.\88\ As 
discussed above, the amendments would require funds relying on an 
Exemptive Rule to comply with rule 0-1(a)(7) and all funds to retain 
records under rule 31a-2. Whether these amendments to the Exemptive 
Rules would affect small entities would depend on whether the small 
entities rely on an Exemptive Rule.\89\ Under rule 31a-2, all small 
entities would be required to maintain records of materials considered 
by a fund board when approving an advisory contract.
---------------------------------------------------------------------------

    \87\ 17 CFR 270.0-10.
    \88\ Some or all of these entities may contain multiple series 
or portfolios. If a registered investment company is a small entity, 
the portfolios or series it contains are also small entities.
    \89\ We now estimate that there are 5,132 registered funds, of 
which 233 are small entities. As discussed in the Proposing Release, 
our staff estimates that approximately 90 percent of all registered 
investment companies, or 4,619 funds, rely on at least one Exemptive 
Rule. If 90 percent of all small entities rely on at least one 
Exemptive Rule, then approximately 210 funds that are small entities 
would rely on at least one Exemptive Rule and would therefore be 
affected by the amendments to the Exemptive Rules. See Proposing 
Release, supra note 2.
---------------------------------------------------------------------------

D. Projected Reporting, Recordkeeping, and Other Compliance 
Requirements

    The amendments do not introduce any new mandatory reporting 
requirements. The amendments contain new mandatory recordkeeping 
requirements. Any fund, regardless of size, is required to maintain 
records of written materials that directors consider to approve an 
advisory contract. The amendments also introduce new compliance 
requirements for any fund that relies on an Exemptive Rule. Any fund 
that relies on an Exemptive Rule is required to satisfy the fund 
governance standards in rule 0-1(a)(7), including having: (i) A board 
of directors whose independent directors constitute at least 75 percent 
of the board; \90\ (ii) an independent director be chairman of the 
board; (iii) directors perform an evaluation of the board and its 
committees, at least once annually; (iv) independent directors meet in 
an executive session at which no director who is an interested person 
of the fund is present, at least once quarterly; and (v) independent 
directors be given specific authority to hire employees and other 
advisers.
---------------------------------------------------------------------------

    \90\ If the board consists of three directors, however, the 
board need only include two independent directors.
---------------------------------------------------------------------------

E. Agency Action to Minimize the Effect on Small Entities

    We are concerned about the impact of these amendments on small 
entities. In response to comments about the impact of the proposed 75 
percent independence requirement on small fund boards, we are adopting 
an alternative for fund boards with only three directors.\91\ Unlike 
fund boards composed of four or more directors, fund boards with only 
three directors would have to be composed of all independent directors 
in order to meet the 75 percent requirement or, alternatively, would 
have increase their board size to four directors. We are adopting an 
alternative to the 75 percent requirement for boards composed of three 
directors that would permit all but one director to be independent. 
With respect to the establishment of other special alternatives for 
small entities, we do not presently think this is feasible or necessary 
because these amendments are designed to strengthen the role of 
independent directors so that fund boards can more effectively manage 
conflicts of interest, monitor service providers, and protect the 
interests of fund shareholders. The need to strengthen the role of 
independent directors arises in part from problems uncovered in 
enforcement actions and settlements. Excepting small entities from the 
amendments could disadvantage fund shareholders of small entities and 
compromise the effectiveness of the amendments. Because we believe that 
small entities are as vulnerable to the problems uncovered in recent 
enforcement actions and settlements as large entities, shareholders of 
small entities are equally in need of more independent fund boards. 
Thus, specific measures must be undertaken by all funds, regardless of 
size, to increase the independence of boards to provide better 
oversight of service providers and compliance matters, to better manage 
conflicts of interest and to better protect fund shareholders.
---------------------------------------------------------------------------

    \91\ We estimate that 30 funds that are small entities have 
boards with only three directors.
---------------------------------------------------------------------------

VIII. Consideration of Promotion of Efficiency, Competition and Capital 
Formation

    Section 2(c) of the Investment Company Act requires the Commission, 
when engaging in rulemaking that requires it to consider or determine 
whether an action is necessary or appropriate in the public interest, 
to consider whether the action will promote efficiency, competition, 
and capital formation. The amendments requiring that funds adopt 
certain governance practices if they rely on any of the Exemptive Rules 
are designed to enhance the independence and effectiveness of fund 
boards. The amendment to require that funds maintain materials 
considered by a fund board when approving an advisory contract is 
designed to improve the documentation of a fund board's basis for 
approving an advisory contract, which would assist our examinations 
staff in determining whether fund directors are fulfilling their 
fiduciary duties when approving advisory contracts. We do not expect 
these amendments to have a significant effect on efficiency, 
competition and capital formation with regard to funds because the 
costs associated with the amendments are minimal and many funds have 
already adopted the required practices. To the extent that these 
amendments do affect competition or capital formation, we believe that 
the

[[Page 46389]]

effect will be positive because the amendments are likely to reduce the 
risk of securities law violations such as late trading in mutual funds 
and market timing violations, and thus increase investor confidence in 
mutual funds. In the Proposing Release, we solicited comments on our 
analysis of the impact of these amendments on efficiency, competition 
and capital formation. We did not receive any comments on our analysis.

Statutory Authority

    We are amending rule 0-1(a) and the Exemptive Rules pursuant to the 
authority set forth in sections 6(c), 10(f), 12(b), 17(d), 17(g), 
23(c), and 38(a) of the Investment Company Act [15 U.S.C. 80a-6(c), 
80a-10(f), 80a-12(b), 80a-17(d), 80a-17(g), 80a-23(c), and 80a-37(a)]. 
We are amending rule 31a-2 under the Investment Company Act pursuant to 
the authority set forth in sections 12(b) and 31(a) [80a-12(b) and 80a-
30(a)].

Text of Rules

List of Subjects in 17 CFR Part 270

    Investment companies, Reporting and recordkeeping requirements, 
Securities.


0
For the reasons set out in the preamble, the Commission is amending 
Title 17, Chapter II of the Code of Federal Regulations as follows.

PART 270--RULES AND REGULATIONS, INVESTMENT COMPANY ACT OF 1940

0
1. The authority citation for Part 270 is amended by adding the 
following citation in numerical order to read as follows:

    Authority: 15 U.S.C. 80a-1 et seq., 80a-34(d), 80a-37, and 80a-
39, unless otherwise noted.
* * * * *
    Section 270.0-1(a)(7) is also issued under 15 U.S.C. 80a-10(e);
* * * * *

0
2. Section 270.0-1 is amended by adding paragraph (a)(7) to read as 
follows:


Sec.  270.0-1  Definition of terms used in this part.

    (a) * * *
    (7) Fund governance standards. The board of directors of an 
investment company (``fund'') satisfies the fund governance standards 
if:
    (i) At least seventy-five percent of the directors of the fund are 
not interested persons of the fund (``disinterested directors'') or, if 
the fund has three directors, all but one are disinterested directors;
    (ii) The disinterested directors of the fund select and nominate 
any other disinterested director of the fund;
    (iii) Any person who acts as legal counsel for the disinterested 
directors of the fund is an independent legal counsel as defined in 
paragraph (a)(6) of this section;
    (iv) A disinterested director serves as chairman of the board of 
directors of the fund, presides over meetings of the board of directors 
and has substantially the same responsibilities as would a chairman of 
a board of directors;
    (v) The board of directors evaluates at least once annually the 
performance of the board of directors and the committees of the board 
of directors, which evaluation must include a consideration of the 
effectiveness of the committee structure of the fund board and the 
number of funds on whose boards each director serves;
    (vi) The disinterested directors meet at least once quarterly in a 
session at which no directors who are interested persons of the fund 
are present; and
    (vii) The disinterested directors have been authorized to hire 
employees and to retain advisers and experts necessary to carry out 
their duties.

0
3. Section 270.10f-3 is amended by:
0
a. Revising the reference to ``paragraphs (b)(1)(iv) and (b)(2)(i)'' to 
read ``paragraphs (c)(1)(v) and (c)(2)(i)'' in paragraph (c)(3);
0
b. Revising the reference to ``paragraph (b)(10)(iii)'' to read 
``paragraph (c)(10)(iii)'' in paragraph (c)(9);
0
c. Revising the reference to ``paragraphs (b)(10)(i) and (b)(10)(ii)'' 
to read ``paragraphs (c)(10)(i) and (c)(10)(ii)'' in paragraph 
(c)(12)(i);
0
d. Revising the reference to ``paragraph (b)(10)(iii)'' to read 
``paragraph (c)(10)(iii)'' in paragraph (c)(12)(ii); and
0
e. Revising paragraph (c)(11).
    The revision reads as follows:


Sec.  270.10f-3  Exemption for the acquisition of securities during the 
existence of an underwriting or selling syndicate.

* * * * *
    (c) * * *
    (11) Board composition. The board of directors of the investment 
company satisfies the fund governance standards defined in Sec.  270.0-
1(a)(7).
* * * * *

0
4. Section 270.12b-1 is amended by revising paragraph (c) to read as 
follows:


Sec.  270.12b-1  Distribution of shares by registered open-end 
management investment company.

* * * * *
    (c) A registered open-end management investment company may rely on 
the provisions of paragraph (b) of this section only if its board of 
directors satisfies the fund governance standards as defined in Sec.  
270.0-1(a)(7);
* * * * *

0
5. Section 270.15a-4 is amended by revising paragraph (b)(2)(vii) to 
read as follows:


Sec.  270.15a-4  Temporary exemption for certain investment advisers.

* * * * *
    (b) * * *
    (2) * * *
    (vii) The board of directors of the investment company satisfies 
the fund governance standards defined in Sec.  270.0-1(a)(7).

0
6. Section 270.17a-7 is amended by revising paragraph (f) to read as 
follows:


Sec.  270.17a-7  Exemption of certain purchase or sale transactions 
between an investment company and certain affiliated persons thereof.

* * * * *
    (f) The board of directors of the investment company satisfies the 
fund governance standards defined in Sec.  270.0-1(a)(7); and
* * * * *

0
7. Section 270.17a-8 is amended by revising paragraph (a)(4) to read as 
follows:


Sec.  270.17a-8  Mergers of affiliated companies.

* * * * *
    (a) * * *
    (4) Board composition. The board of directors of the Merging 
Company satisfies the fund governance standards defined in Sec.  270.0-
1(a)(7).
* * * * *

0
8. Section 270.17d-1 is amended by revising paragraph (d)(7)(v) to read 
as follows:


Sec.  270.17d-1  Applications regarding joint enterprises or 
arrangements and certain profit-sharing plans.

* * * * *
    (d) * * *
    (7) * * *
    (v) The board of directors of the investment company satisfies the 
fund governance standards defined in Sec.  270.0-1(a)(7).
* * * * *

0
9. Section 270.17e-1 is amended by revising paragraph (c) to read as 
follows:


Sec.  270.17e-1  Brokerage transactions on a securities exchange.

* * * * *
    (c) The board of directors of the investment company satisfies the 
fund governance standards defined in Sec.  270.0-1(a)(7); and
* * * * *

[[Page 46390]]


0
10. Section 270.17g-1 is amended by revising paragraph (j)(3) to read 
as follows:


Sec.  270.17g-1  Bonding of officers and employees of registered 
management investment companies.

* * * * *
    (j) * * *
    (3) The board of directors of the investment company satisfies the 
fund governance standards defined in Sec.  270.0-1(a)(7).
* * * * *

0
11. Section 270.18f-3 is amended by revising paragraph (e) to read as 
follows:


Sec.  270.18f-3  Multiple class companies.

* * * * *
    (e) The board of directors of the investment company satisfies the 
fund governance standards defined in Sec.  270.0-1(a)(7).
* * * * *

0
12. Section 270.23c-3 is amended by revising paragraph (b)(8) to read 
as follows:


Sec.  270.23c-3  Repurchase offers by closed-end companies.

* * * * *
    (b) * * *
    (8) The board of directors of the investment company satisfies the 
fund governance standards defined in Sec.  270.0-1(a)(7).
* * * * *

0
13. Section 270.31a-2 is amended by:
0
a. Removing the word ``and'' at the end of paragraph (a)(4);
0
b. Removing the period at the end of paragraph (a)(5) and adding in its 
place ``; and''; and
0
c. Adding paragraph (a)(6) to read as follows:


Sec.  270.31a-2  Records to be preserved by registered investment 
companies, certain majority-owned subsidiaries thereof, and other 
persons having transactions with registered investment companies.

    (a) * * *
    (6) Preserve for a period not less than six years, the first two 
years in an easily accessible place, any documents or other written 
information considered by the directors of the investment company 
pursuant to section 15(c) of the Act (15 U.S.C. 80a-15(c)) in approving 
the terms or renewal of a contract or agreement between the company and 
an investment adviser.
* * * * *

    Dated: July 27, 2004.

    By the Commission.
Margaret H. McFarland,
Deputy Secretary.

Dissent of Commissioners Cynthia A. Glassman and Paul S. Atkins 
Investment Company Governance, Release No. IC-26520

    We write jointly to dissent from the Commission's adoption of 
amendments to rules under the Investment Company Act of 1940 
(``Investment Company Act'' or ``Act'') that generally require a 
fund's board of directors: (1) To be composed of directors, at least 
75 percent of whom are independent, and (2) to be led by an 
independent director as its chairperson.\1\ We support the 
rulemaking's commendable objective of strengthening investor 
protection for fund shareholders. However, we fear that the path 
chosen to achieve this objective may lead in the opposite 
direction--at a substantial cost to fund shareholders. Because the 
fund industry is a $7.6 trillion industry, it is easy to ignore or 
lose sight of the fact that the costs of regulatory requirements are 
ultimately paid by fund shareholders, for whom small differences in 
fees are of great importance.\2\
---------------------------------------------------------------------------

    \1\ The change is effected by making these governance 
requirements conditions of ten commonly used exemptive rules. 
Because these rules are used by virtually all funds, these 
requirements are effectively universally applicable.
    \2\ See, e.g., Securities and Exchange Commission, Invest 
Wisely: An Introduction to Mutual Funds (available at: http://
www.sec.gov/investor/pubs/inwsmf.htmkey) (``Even small 
differences in fees can translate into large differences in returns 
over time. For example, if you invested $10,000 in a fund that 
produced a 10% annual return before expenses and had annual 
operating expenses of 1.5%, then after 20 years you would have 
roughly $49,725. But if the fund had expenses of only 0.5%, then you 
would end up with $60,858--an 18% difference.'').
---------------------------------------------------------------------------

    As the release indicates, although the benefits of the 
amendments are difficult to quantify, a majority of the Commission 
``believe[s] they are real.'' \3\ The majority postulates that the 
new independence requirements will ``strengthen the hand of the 
independent directors when dealing with fund management, and may 
assure that independent directors maintain control of the board and 
its agenda.'' \4\ However, despite the existence of empirical data 
that could have been analyzed to evaluate potential benefits, the 
proponents provided no such analysis. Moreover, the majority 
speculates sanguinely that the benefits of these amendments will 
come at ``minimal'' cost to funds.\5\ Positing that empirical 
evidence is unnecessary, the majority dismisses pleas for more 
deliberate action.\6\ A particular standard of independence is not, 
in and of itself, a legitimate regulatory objective. Therefore, 
before we mandate that all funds meet any particular independence 
standard, it must be objectively linked (by more than anecdotal 
evidence and ``gut impression'') to real benefits for shareholders.
---------------------------------------------------------------------------

    \3\ See Section VI.A of the Adopting Release (``Benefits'').
    \4\ See Adopting Release, text accompanying note 75.
    \5\ See Section VIII of the Adopting Release (Consideration of 
Promotion of Efficiency, Competition and Capital Formation'').
    \6\ See Securities and Exchange Commission, Open Meeting 
Webcast, June 23, 2004 (available at: http://www.sec.gov/news/openmeetings.shtml) (dissenting views on the value of empirical 
data).
---------------------------------------------------------------------------

Existing Independence Requirements Are Sufficient To Ensure 
Meaningful Influence

    Existing statutory and regulatory requirements already ensure 
that independent directors can make their voices heard and heeded. 
In enacting the Investment Company Act, Congress prescribed a fund 
board's independence requirements. Section 10(a) of the Investment 
Company Act requires that at least forty percent of a fund's board 
be independent.\7\ Section 10(b)(2) of the Act requires, in effect, 
that independent directors comprise a majority of a fund's board if 
the fund's principal underwriter is an affiliate of the fund's 
adviser.\8\ Moreover, certain board actions cannot be taken without 
approval by a majority of the independent directors. Most 
importantly, section 15(c) provides that a majority of the 
independent directors must approve advisory and underwriting 
contracts.\9\ Certain Commission exemptive rules also require a 
majority vote by the independent directors in specific areas of 
conflict.\10\ In addition, three years ago the Commission 
conditioned ten of its commonly-used exemptive rules on fund boards' 
having a majority of independent directors.\11\ These rules are the 
same rules the Commission is amending today.\12\
---------------------------------------------------------------------------

    \7\ See section 10(a). 15 U.S.C. 80a-10(a). Congress initially 
considered, but later rejected a majority independence requirement 
because of concerns ``that if a person is buying management of a 
particular person and if the majority of the board can repudiate his 
advice, then in effect, you are depriving the stockholders of that 
person's advice.'' Investment Trusts and Investment Companies: 
Hearings on H.R. 10065 Before the House Subcomm. on Interstate and 
Foreign Commerce, 76th Cong., 3d Sess. 109-110 (1940) (testimony of 
David Schenker). Since approximately 90 percent of funds utilize 
these exemptive rules, the majority is effectively mandating these 
changes for all funds. See Adopting Release at note 88. Given the 
clearly stated, legislatively prescribed independence mandates, we 
question whether the Commission is acting outside its authority 
under the Investment Company Act.
    \8\ 15 U.S.C. 80a-10(b)(2). See also section 10(c) (a majority 
of the board of a registered investment company may not consist of 
persons who are officers, directors, or employees of any one bank or 
bank holding company).
    \9\ 15 U.S.C. 80a-15(c). See also section 32(a)(1) of the Act (a 
fund's auditor must be selected by the vote of a majority of the 
fund's independent directors).
    \10\ Rule 17a-7, for example, requires that fund directors, 
including a majority of the independent directors, determine at 
least quarterly that all affiliated purchase and sale transactions 
were made in compliance with procedures adopted by the board, 
including a majority of the independent directors. 17 CFR 270.17a-7.
    \11\ Role of Independent Directors of Investment Companies, 
Investment Company Act Release No. 24816 (Jan. 2, 2001) [66 FR 3734 
(Jan. 16, 2001)] (``2001 Adopting Release'').
    \12\ See Adopting Release at note 8.
---------------------------------------------------------------------------

    The existing independence requirements already enable 
independent directors to set the agenda and determine the outcome of

[[Page 46391]]

decisions made by the board.\13\ As the Commission noted three years 
ago, a majority requirement is sufficient to ``permit, under state 
law, the independent directors to control the fund's ``corporate 
machinery,'' i.e., to elect officers of the fund, call meetings, 
solicit proxies, and take other actions without the consent of the 
adviser.'' \14\ ``[I]ndependent directors who comprise the majority 
of a board can have a more meaningful influence on fund management 
and represent shareholders from a position of strength.'' \15\ A 
majority of independent directors also can insist, if they determine 
that it would be beneficial, on an independent chairperson.
---------------------------------------------------------------------------

    \13\ Last year, the staff noted the power already possessed by 
fund independent directors: ``[A]lmost all funds have boards with at 
least a majority of independent directors. Thus, one could question 
whether there is a need to mandate that a fund's chairman be 
independent because independent directors representing a majority of 
a fund's board already are in a position to control the board and, 
if they deemed it appropriate, could already influence the agenda 
and the flow of information to the board.'' Memorandum from Paul F. 
Roye, Director, Division of Investment Management, to William H. 
Donaldson, Chairman, SEC, re Correspondence from Chairman Richard H. 
Baker, House Subcommittee on Capital Markets, Insurance and 
Government Sponsored Enterprises, at 50 (June 9, 2003) (available 
at: http://financialservices. house.gov/media/pdf/02-14-70%20memo.pdf) (``Baker Memorandum'').
    \14\ 2001 Adopting Release at text accompanying note 22.
    \15\ 2001 Adopting Release at text accompanying note 23.
---------------------------------------------------------------------------

    We are particularly troubled that the Commission has not shown 
that the reforms from three years ago were inadequate to achieve the 
stated goals. The new independence conditions took effect on July 1, 
2002, so the Commission has allowed itself only two years to observe 
the effects of the amendments. Most importantly, the Commission has 
not even attempted the barest systematic assessment of the 
effectiveness either of those reforms or, more generally, of the 
statutory and rule-based fund governance requirements. We are also 
troubled that at the same time the majority raises the requirement 
for the number of independent directors, it notes that the directors 
who are legally ``independent'' may not really be independent.\16\ 
The majority's concerns suggest a possible need for a change in the 
statutory definition of ``interested person'' under section 2(a)(19) 
of the Act rather than for an increase in the number of independent 
directors.\17\
---------------------------------------------------------------------------

    \16\ See Section II.C of the Adopting Release.
    \17\ ``Independent director'' is a term commonly used to refer 
to a director who is not an ``interested person'' as defined in 
section 2(a)(19). 15 U.S.C. 80a-2(a)(19). The Commission, of course, 
would need to petition Congress for such a change. Indeed, last year 
the staff asked Congress to consider revising section 2(a)(19) of 
the Act to give the Commission ``rulemaking authority to fill gaps 
in the statute that have permitted persons to serve as independent 
directors despite relationships that suggest a lack of independence 
from fund management.'' See Baker Memorandum, supra note 13, at 47.
---------------------------------------------------------------------------

A Seventy-Five Percent Independence Threshold Is Unnecessary

    The majority's choice of seventy-five percent is puzzling. The 
majority points to the only section in the Investment Company Act 
that dictates this percentage, section 15(f).\18\ The majority does 
not explain that section 15(f) is a safe harbor provision that 
``make[s] clear that an investment adviser can make a profit on the 
sale of its business subject to two principal safeguards to protect 
the investment company and its shareholders.'' \19\ Congress did not 
intend for it to serve as a universally-applicable requirement for 
fund boards.
---------------------------------------------------------------------------

    \18\ 15 U.S.C. 80a-15(f). Section 15(f) requires funds to 
maintain boards comprising at least seventy-five percent independent 
directors for the three-year period after an adviser has sold its 
advisory business to another entity. This provision was added by 
Congress to limit the effects of Rosenfeld v. Black, 445 F.2d 1337 
(2d Cir. 1971). In that case, the court had held that it was a 
violation of an adviser's fiduciary duty to transfer an advisory 
contract to another adviser for profit.
    \19\ Committee on Banking, Housing and Urban Affairs, Report No. 
94-75 to Accompany S. 249 (Apr. 14, 1975).
---------------------------------------------------------------------------

    The Commission could have imposed a two-thirds independence 
requirement, which most funds already satisfy, is consistent with 
best practices recommendations from the Investment Company 
Institute,\20\ and was contemplated (but rejected in favor of a 
majority requirement) in connection with the 2001 fund governance 
changes.\21\ Instead, the majority has chosen a seventy-five percent 
minimum, which forces approximately half of funds to make 
changes.\22\ Again, the majority fails to give any real 
consideration to the costs of this change. The Adopting Release 
acknowledges that ``our staff has no reliable basis for determining 
how funds would choose to satisfy [the seventy-five percent] 
requirement and therefore it is difficult to determine the costs 
associated with electing independent directors.'' \23\ Fund boards 
are able to avoid incurring the costs of hiring new independent 
directors by reducing the number of directors, but even this 
approach is likely to impose some costs, not the least of which is 
the loss of the insight and experience of directors who are removed 
from the board. Funds that conclude that it is in the interest of 
fund shareholders to retain existing interested directors will need 
to hire additional independent directors, a costly prospect.\24\
---------------------------------------------------------------------------

    \20\ See Investment Company Institute, Report of the Advisory 
Group on Best Practices for Fund Directors: Enhancing a Culture of 
Independence and Effectiveness at 10-12 (June 24, 1999) (available 
at: http://www.ici.org/pdf/rpt_best_practices.pdf).
    \21\ See 2001 Adopting Release at note 25. The majority, 
conceding that ``there are good arguments for maintaining a 
management presence on the board,'' portrays itself as reasonable 
because it rejected the higher independence percentages recommended 
by some commenters. See Adopting Release at note [31] and 
accompanying text (citing Letter of Tom Walker to Jonathan G. Katz, 
Secretary, SEC (Mar. 9, 2004)), File No. S7-03-04 (``While your 
changes are moving in the right direction in advocating for a more 
independant [sic] boards. I believe it still allows for too much 
room for cornyism [sic] and nepotism to play out on what should be 
truley [sic] independant [sic] directors.''); Letter of John and 
Judy Hesselberth to Jonathan G. Katz, Secretary, SEC (Feb. 24, 
2004), File No. S7-03-04 (``In addition the requirement that 75% of 
the directors of a mutual fund must be outside directors is sound. 
It probably should be 100%, but 75 is a step in the right direction 
from the current 50%.'').
    \22\ See Letter from Craig S. Tyle, General Counsel, Investment 
Company Institute, to Jonathan G. Katz, Secretary, SEC (Mar. 10, 
2004), File No. S7-03-04 (stating that ``a change from the current 
[common industry] practice of a two-thirds supermajority to a 
seventy-five percent requirement would mean that at least half of 
all fund boards would have to change their current composition, 
according to Institute data.'').
    \23\ Adopting Release at text accompanying note [79] (footnote 
omitted).
    \24\ A survey found that in 2002, the median compensation for 
independent directors at the 50 largest fund groups was $113,000 a 
year and at the smaller fund groups was $18,000. See Rick Miller, In 
Off Year, these Cats Get Fatter: Fund Board Directors Collect a Big 
Pay Raise, Investment News, April 7, 2003, at 1 (reporting results 
of a survey conducted by Management Practice Inc.). This amount, of 
course, does not include up-front search costs and annual non-
compensation costs associated with a director's performance of his 
or her duties.
---------------------------------------------------------------------------

Mandating an Independent Chairperson Is Unwarranted

    The rulemaking is characterized as being part of the solution to 
the late trading, market timing, and other fund abuses that have 
come to light over the past year. Its proponents claim that the 
enforcement cases we have brought to date in this area exhibit a 
telling pattern--approximately eighty percent of the funds involved 
had inside chairpersons.\25\ However, because approximately eighty 
percent of all fund firms have interested chairpersons, this number 
suggests only that funds with inside chairpersons are proportionally 
implicated in the abusive activity. A common feature of these 
enforcement actions is that boards were not told of the formal or 
informal arrangements permitting market timing. An inside 
chairperson with access to information about day-to-day operations 
might be more likely than an independent chairperson to discover 
practices that are harmful to fund shareholders.\26\
---------------------------------------------------------------------------

    \25\ See, e.g., Letter from Congressman Michael G. Oxley to 
Chairman William H. Donaldson (May 20, 2004).
    \26\ In pointing out this and other potential benefits that an 
interested chairperson might bring to a fund board, we do not intend 
to suggest that all boards should select an interested chairperson. 
To the contrary, we maintain that what works well for one fund board 
might not work well for every other fund board. Under certain 
circumstances, a fund board might conclude that an independent 
chairperson is essential. See, e.g., Tom Lauricella, Strong Steps 
Down from Fund Board but Stays on as Head of Firm, Wall St. J., Nov. 
3, 2003, at C12 (reporting that following Richard Strong's 
resignation from his post as chairman of the board of the Strong 
Mutual Funds, ``[t]he independent Strong directors have begun a 
search to replace Mr. Strong with a chairman who is independent from 
Strong Capital management'').
---------------------------------------------------------------------------

    When the amendments were proposed, we asked that a more thorough 
analysis be undertaken before effecting these significant changes in 
an industry that is of such importance to so many investors.\27\

[[Page 46392]]

Proponents of the rule undertook no such analysis, and the 
Commission did not use its resources to conduct such an analysis. 
The burden of proof lies with the regulator seeking to overturn the 
status quo rather than with the regulated.\28\ The empirical data we 
did receive suggest that the amendments might not be beneficial. The 
data show a correlation between an inside chairperson and superior 
performance and no statistically significant negative effect on 
fees.\29\ Indeed, many of the funds that report the best performance 
and lowest fees have inside chairpersons.\30\
---------------------------------------------------------------------------

    \27\ At the Commission Open Meeting during which the Commission 
voted to propose the amendments, Commissioner Glassman requested 
that proponents and/or staff provide empirical data that would 
support the amendments.
    \28\ The application of ``Total Quality Management,'' the 
management philosophy of W. Edwards Deming, and a later variant, 
``Six Sigma,'' would emphasize the importance of discerning whether 
the fund advisers' fraudulent activity (the variation from desired 
results) derives from a common cause or something aberrant in a 
particular adviser's management process--that is, a special cause. 
If common causes are to blame for the fraudulent activity, then the 
system is flawed and redesign is necessary. Special causes require 
more targeted solutions. As discussed below, the fact that funds 
with independent chairpersons seem proportionally implicated in this 
fraudulent activity indicates that the lack of an independent 
chairperson is not a common cause for the fraudulent activity by 
fund advisers. In addition, the empirical data that we have found 
this far supports this observation. Consequently, a redesign of the 
fund governance system is not indicated by the data. The majority's 
redesign of the system will not, and cannot be expected to, cure the 
flaws of the system.
    \29\ See Geoffrey H. Bobroff and Thomas H. Mack, Assessing the 
Significance of Mutual Fund Board Independent Chairs, A Study for 
Fidelity Investments (Mar. 10, 2004) (attached to letter from Eric 
D. Roiter, Senior Vice President and General Counsel, Fidelity 
Management & Research Company to Jonathan G. Katz, SEC (Mar. 10, 
2002), File No. S7-03-04)). In an effort to support its position and 
rebut challenges that it has not considered any empirical evidence, 
the majority laments the fact that commenters did not submit any 
pre-existing studies and dismisses the findings of this study, which 
was commissioned in response to the Commission's request for 
comments on the proposed amendments. See Adopting Release at note 
51. The majority's intimation that the data must be discounted 
because of the ``prevalence of independent chairmen among bank-
sponsored fund groups'' is troubling if it is intended to suggest 
that bank-sponsored mutual funds are inherently inferior to their 
non-bank counterparts. We acknowledge that one study cannot 
conclusively resolve the debate about independent chairpersons, but 
its conclusions contribute to the debate. Boards of directors, not 
the Commission, should weigh the evidence to decide whether an 
independent chairperson would be beneficial for their fund 
shareholders.
    \30\ Id.
---------------------------------------------------------------------------

    A fact largely ignored by this rulemaking is that independent 
directors are not the only ones charged with protecting the 
interests of fund shareholders. An investment adviser has a 
fiduciary duty to act in the best interests of a fund it 
advises.\31\ Further, all fund directors have a fiduciary duty to 
shareholders.\32\ It is true that fund managers serve two 
constituencies--shareholders of the adviser and shareholders of the 
fund. The interests of these two groups are not, however, entirely 
at odds. Interested fund directors have an incentive to maximize 
fund performance because good performance matters to fund investors, 
who factor it into their investment decisions. Thus, market forces 
compel fund advisers to offer fund shareholders good performance for 
a reasonable fee in order to preserve the integrity and hence, 
marketability, of its brand. This rulemaking overlooks these market 
forces and seems to suggest that there is no counterweight to the 
pressure to impose fees on the fund.
---------------------------------------------------------------------------

    \31\ See Rosenfeld v. Black, 445 F.2d 1337 (2d Cir. 1971); Brown 
v. Bullock, 194 F. Supp. 207, 229, 234 (S.D.N.Y.), aff'd, 294 F.2d 
415 (2d Cir. 1961). See also section 36(b) of the Investment Company 
Act [15 U.S.C. 80a-35(b)] (investment adviser of a fund has a 
fiduciary duty with respect to the receipt of compensation paid by 
the fund). More generally, investment advisers owe a fiduciary duty 
to their clients. SEC v. Capital Gains Research Bureau, 375 U.S. 
180, 191 (1963) (interpreting section 206 of the Investment Advisers 
Act of 1940).
    \32\ In addition to standard state law duties applicable to all 
corporate directors, fund directors have fiduciary duties under the 
Investment Company Act. See section 36(a) of the Investment Company 
Act. [15 U.S.C. 80a-35(a)].
---------------------------------------------------------------------------

    Concluding nonetheless that investors would benefit from an 
independent chairperson, the majority ignores the costs fund 
investors will bear by the adoption of this requirement.\33\ The 
majority did not identify ``any out-of-pocket costs'' associated 
with the independent chairperson requirement. Yet an estimated 
eighty percent of funds will need a new chairperson. If a sitting 
independent director accepts the position, the fund will need to pay 
him more to accept the new responsibilities.\34\ If none of the 
sitting independent directors wants the job or none is 
qualified,\35\ the fund will need to launch an expensive search. It 
may be difficult for funds to find an individual with the requisite 
industry experience whom they can afford to hire.
---------------------------------------------------------------------------

    \33\ See Section VI.B (``Costs'') of the Adopting Release.
    \34\ According to one estimate, an independent chairperson could 
command a 25 to 50% premium over other board members. See Beagan 
Wilcox, Wanted: Independent Chairmen, Board IQ, July 6, 2004 (citing 
estimate of Meyrick Payne, senior partner, Management Practice).
    \35\ Independent directors have ``diverse backgrounds in 
business, government or academia.'' Investment Company Institute, 
Understanding the Role of Mutual Fund Directors, at 6. Fund 
independent directors without experience in the fund industry can 
apply their experiences in other areas to perform their 
responsibilities as independent directors, but may not be adequately 
equipped to handle responsibilities of board chairperson.
---------------------------------------------------------------------------

    Moreover, in order to be effective at carrying out his or her 
responsibilities, an independent chairperson likely would have to 
hire a staff.\36\ The majority addresses this issue only in passing 
by stating that the ``staff is not aware of any costs associated 
with hiring employees or retaining experts because boards typically 
have this authority under state law, and the rule would not 
require'' that an independent chairperson hire employees.\37\ We 
cannot support a rule that rests upon such tortured logic and 
circular reasoning. As some commenters have noted, it is ironic that 
the majority, in its zeal to strengthen the independence of fund 
boards, has enacted a measure that takes away that independence of 
the board to select its own chairperson.\38\
---------------------------------------------------------------------------

    \36\ Of necessity, both the independent chairperson and his or 
her staff are likely to be dependent on fund management and, 
therefore, may lose independent perspective on matters facing the 
board. Sir Derek Higgs recognized this in his review of corporate 
governance in Britain. See Derek Higgs, Review of the Role and 
Effectiveness of Non-Executive Directors (Jan. 2003) at 24 
(explaining that, even if a chairperson is independent prior to 
appointment, thereafter he or she will work closely with management 
in carrying out his or her duties, so ``[a]pplying a test of 
independence at this stage is neither appropriate nor necessary.'').
    \37\ See Section VI.B (``Costs'') of the Adopting Release.
    \38\ The majority reassures independent directors that the 
amendments ``do not prevent the independent directors from choosing 
the most qualified and capable candidate.'' See Adopting Release, at 
text following note 47. We contend that a conscientious board might 
reasonably determine that the most qualified and capable candidate 
is someone with the deep familiarity with day-to-day fund 
operations. The majority apparently believes they know better.
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The Commission Failed To Examine Alternatives

    We fear that the Commission is acting simply to appear 
proactive. The Commission already has taken significant steps to 
address the recently uncovered abuses in the fund industry and to 
identify and address other potentially problematic issues. We have 
brought enforcement actions under existing laws and regulations to 
punish the wrongdoers.\39\ We have also initiated meaningful 
regulatory reform. Recently, for example, we adopted requirements 
regarding the disclosure of market-timing policies,\40\ enhancing 
the disclosure provided by funds about how their boards evaluate and 
approve investment advisory contracts,\41\ and requiring funds and 
advisers to designate chief compliance officers.\42\ In addition, we 
are considering initiatives on fair value pricing,\43\ increased 
transparency of fund transaction costs and expenses,\44\ pricing of

[[Page 46393]]

fund shares,\45\ and fund distribution arrangements.\46\
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    \39\ See Adopting Release at note 5.
    \40\ Disclosure Regarding Market Timing and Selective Disclosure 
of Portfolio Holdings, Investment Company Act Release No. 26418 
(Apr. 19, 2004) [69 FR 22300 (Apr. 23, 2004)].
    \41\ Disclosure Regarding Approval of Investment Advisory 
Contracts by Directors of Investment Companies, Investment Company 
Act Release 26486 (June 23, 2004) [69 FR 39798 (June 30, 2004)].
    \42\ Compliance Programs of Investment Companies and Investment 
Advisers, Investment Advisers Act Release No. 2204 (Dec. 17, 2003) 
[68 FR 74714 (Dec. 24, 2003)].
    \43\ These initiatives are described in Mandatory Redemption 
Fees for Redeemable Fund Securities, Investment Company Act Release 
No. 26375A at Section II.F (Mar. 5, 2004) [69 FR 11762 (Mar. 11, 
2004)].
    \44\ See Confirmation Requirements and Point of Sale Disclosure 
Requirements for Transactions in Certain Mutual Funds and Other 
Securities, and Other Confirmation Requirement Amendments, and 
Amendments to the Registration Form for Mutual Funds, Investment 
Company Act Release No. 26341 (Jan. 29, 2004) [69 FR 6438 (Feb. 10, 
2004)] and Request for Comments on Measures to Improve Disclosure of 
Mutual Fund Transaction Costs, Investment Company Act Release No. 
26313 (Dec. 18, 2003).
    \45\ Amendments to Rules Governing Pricing of Mutual Fund 
Shares, Investment Company Act Release No. 26288 (Dec. 11, 2003) [68 
FR 70388 (Dec. 17, 2003)].
    \46\ Prohibition on the Use of Brokerage Commissions to Finance 
Distribution, Investment Company Act Release No. 26356 (Feb. 24, 
2004) [69 FR 9726 (Mar. 1, 2004)].
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    We were hopeful when these board governance amendments were 
proposed that alternative measures would be considered. Requiring a 
fund to disclose prominently whether or not it had an independent 
chairperson, for example, would allow shareholders to decide whether 
that matters to them or not. Alternatively, we could have endorsed 
the lead independent director concept by requiring a fund's 
independent directors to appoint a lead director to represent the 
views of the fund's independent directors to fund management.\47\ We 
could have required additionally that each major board committee be 
chaired by an independent director, who would have the authority to 
set the agenda of the committee. The advantage of these 
alternatives, in addition to being less costly, is that they leave 
the decision about the independent chairperson to the independent 
directors or the marketplace, rather than impose the requirement by 
regulatory fiat. The majority failed to give serious consideration 
to these alternatives.\48\
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    \47\ In 1999, the Investment Company Institute's Advisory Group 
on Best Practices for Fund Directors included among its 
recommendations the designation of one or more persons as a lead 
director. See Investment Company Institute, Report of the Advisory 
Group on Best Practices for Fund Directors: Enhancing a Culture of 
Independence and Effectiveness at 25 (June 24, 1999) (available at: 
http://www.ici.org/pdf/rpt_best_practices.pdf).
    \48\ The majority acknowledged that these alternatives could be 
useful, but explained that funds would have difficulty finding 
persons of ``sufficient stature'' to act as ``an effective 
counterweight to a fund chairman who may also be the chief executive 
officer of the management company.'' See Adopting Release at text 
accompanying note 57. We question whether funds will find it easier 
to fill the position of independent chairperson with a person able 
both to act as an ``effective counterweight'' and also to fulfill 
the routine administrative responsibilities of running a fund board.
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    Under the cover of ``good atmospherics'' and the shroud of 
``investor protection,'' the majority has decided to adopt measures 
the benefits of which are illusory, but the costs of which are real. 
We conclude that the majority has not justified this forced 
restructuring of the corporate governance of the vast majority of 
funds and fear that it provides investors with a false sense of 
security.
    For the foregoing reasons, we respectfully dissent.

Cynthia A. Glassman,

Commissioner.

Paul S. Atkins,
Commissioner.

[FR Doc. 04-17460 Filed 7-30-04; 8:45 am]
BILLING CODE 8010-01-P