Co-written by David Kanefsky

Withstanding a barrage of criticism from many members in the asset management industry, the Securities and Exchange Commission (the "SEC") adopted a broad set of final rules and amendments governing the independence of investment company directors.1 Back in May 2000, we distributed a memorandum discussing the controversial proposal by the SEC to enhance significantly the role of the independent (or "disinterested") directors in fund governance; after a lengthy comment period, the SEC has finally acted on its proposal.

Set forth below is a summary of the newly adopted rules and amendments. In large part, the new rules have been enacted as they were originally proposed by the SEC; any significant differences from the proposal are highlighted below.

Summary

The SEC, recognizing the critical role that the independent directors play in protecting fund investors, adopted a variety of new rules and amendments that may be sorted into three broad categories.

First, new director independence standards apply to investment companies that rely on any of 10 commonly-used exemptive rules (collectively, the "Exemptive Rules") under the Investment Company Act of 1940, as amended (the "1940 Act").2 For funds relying on the Exemptive Rules:

  1. independent directors must constitute a majority of the directors;
  2. independent directors must select and nominate any other independent directors; and
  3. if such funds choose to have their independent directors represented by counsel, the counsel must be independent.

Second, new disclosure standards apply to all investment companies, mandating that funds provide improved information regarding the fund directors in their registration statements, proxy statements for the election of directors and annual reports to shareholders. Going forward, each fund will be required to disclose the following:

  1. basic information about the identify and experience of directors;
  2. fund shares owned by directors;
  3. information about directors that may raise concerns of conflicts of interest; and
  4. information about the board’s role in governing the fund.

Third, in a "catchall" category, the other rules and amendments:

  1. prevent qualified individuals from being unnecessarily disqualified from serving as independent directors;
  2. protect independent directors from the costs of legal disputes with fund management;
  3. permit the SEC to monitor the independence of directors by requiring funds to keep records of their assessments of director independence;
  4. temporarily suspend the independent director minimum percentage requirements if a fund falls below a required percentage due to an independent director's death or resignation; and
  5. exempt funds from the requirement that shareholders ratify or reject the directors' selection of an independent public accountant, if the fund establishes an audit committee composed entirely of independent directors.

Discussion

A. Amendments To Exemptive Rules

(i) Majority Of The Directors Must Be Independent Directors.

The amendments require that, for funds relying on any of the Exemptive Rules, a majority of the board (i.e., more than half of the members) must be comprised of independent directors. The amendments are designed to increase the ability of independent directors to perform their important responsibilities under each of the Exemptive Rules. Additionally, the changes allow 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 fund’s investment adviser or the interested directors.

For those funds that choose not to rely on the Exemptive Rules (in reality, a very small group), the 1940 Act generally requires that only 40% of the fund’s board must be comprised of independent directors.

The SEC’s original proposal had considered adopting a stricter supermajority (two-thirds) requirement for independent directors; however, the SEC opted instead for a simple majority standard for board composition.

(ii) Independent Directors Must Select And Nominate Any Other Independent Directors.

Under the amendments, funds that rely on the Exemptive Rules must allow the incumbent independent directors to select and nominate any other independent directors. Selection and nomination refers to "the process by which board candidates are researched, recruited, considered and formally named."3 Although a fund’s shareholders or its investment adviser may suggest candidates, it is ultimately the responsibility of the independent directors to canvass, recruit, interview, solicit and nominate new independent directors. This requirement is intended to help those funds that do not currently have a majority of independent directors on their board reach the new minimum threshold. Limiting the process solely to the existing independent directors fosters an independent-minded board that focuses primarily on the interests of a fund's investors rather than its investment adviser.

(iii) If Independent Directors Are Represented By Counsel, The Counsel Must Be Independent.

The most controversial of the SEC’s original proposals was the requirement that counsel for the independent directors must be "independent". Most investment companies and investment advisers in the industry, and a number of independent directors and their lawyers, opposed the requirement of an "independent legal counsel." They argued that the selection of counsel was a discretionary matter that should be left to the independent directors, and that imposing the independent counsel requirement could deny independent directors the use of competent counsel from larger law firms with many potential conflicts.

Disagreeing with this popular sentiment, the SEC amended the Exemptive Rules to require that any counsel that is hired for the independent directors must be independent. The aim is to have counsel to the independent directors be persons who are free of significant conflicts of interest that might affect their legal advice. We note that funds are not required to retain counsel for their independent directors, but if they do so, then such counsel must be an "independent legal counsel." Counsel is considered to be an "independent legal counsel" if, in part,

"A majority of the disinterested directors reasonably determine in the exercise of their judgment (and record the basis for that determination in the minutes of their meeting) that any representation by the person of the company's investment adviser, principal underwriter, administrator ("management organizations"), or any of their control persons, since the beginning of the fund's last two completed fiscal years, is or was sufficiently limited that it is unlikely to adversely affect the professional judgment of the person in providing legal representation to the disinterested directors . . . ."4

On this point, the amendment as adopted is more flexible than the original proposal, which stated that either the independent counsel would not have represented the management organizations (or their control persons), or the independent directors must find that the representation "is or was so limited that it would not adversely affect the person's ability to provide impartial, objective, and unbiased legal counsel."5 The Adopting Release emphasizes the SEC's reliance on the independent directors' judgment.

In evaluating whether potentially conflicting representations are "sufficiently limited," independent directors should consider all relevant factors, including, when appropriate, the following seven factors set forth in the Adopting Release:

  1. whether the representation is current and ongoing;
  2. whether it involves a minor or substantial matter;
  3. whether it involves the fund, the adviser or an affiliate, and if an affiliate, the nature and the extent of the affiliation;
  4. the duration of the potentially conflicting representation;
  5. the importance of the representation to counsel and his or her firm (including the extent to which counsel relies on that representation economically);
  6. whether it involves work related to mutual funds; and
  7. whether the individual who will serve as legal counsel was or is involved in the representation.

While these various factors are helpful guidelines, they are not meant to be dispositive, and above all the independent directors should rely on their business judgment to determine the independence of counsel.

Although the proposed amendment required only a one-time determination of counsel’s independence, the amendment as adopted requires the independent directors to reconsider the determination annually. The basis for the determination must be recorded in the board's minutes, but can be based on counsel's representations. In making their determination, the independent directors must consider any conflicting representations of their individual attorney, as well as that attorney’s law firm, partners and employees.

The new amendments require that the independent directors obtain an undertaking from counsel to provide them information necessary for the directors to determine whether such counsel is an "independent legal counsel", and to update promptly that information if counsel begins or materially increases the representation of a management organization. If a counsel does begin to represent a management organization, there is a three-month grace period of deemed independence, after which the independent directors must either make a new finding of independence or terminate the counsel relationship.6

It will be interesting to see what special disclosures, if any, the Staff mandates in annual or other reports or proxy materials filed with it concerning the independent counsel and the directors’ assessment of such counsel’s independence in cases where an independent counsel has been retained by an investment company’s independent directors.

The compliance date for reliance on the Exemptive Rules is July 1, 2002.

B. Greater Disclosure Information.

Pursuant to the Adopting Release, investment companies must now provide to their shareholders greater information about their directors. Specifically, each fund must disclose, separately for the interested directors and the independent directors, each of the following:

(i) Basic information about the identity and experience of directors.

This information is to be set forth in a table in three places: (1) the fund’s annual report to shareholders, (2) the fund’s Statement of Additional Information (the "SAI") and (3) any proxy statement for the election of the fund’s directors. The table requires disclosure for each director regarding his or her:

  1. name, address and age;
  2. current positions held with the fund;
  3. term of office and length of time served;
  4. principal occupations during the past five years;
  5. number of portfolios overseen within the fund complex; and
  6. other directorships held outside the fund complex.7

The table also should include, for each interested director, a description of the relationship, events or transactions that cause the director to be an interested person.

(ii) The amount of equity securities of funds in a fund complex beneficially owned by each director.

This enables shareholders to assess whether the directors’ interests are aligned with those of the shareholders. As adopted, the new rules require disclosure of the dollar ranges (in groups from $0-$100,000) of (x) each director’s beneficial ownership in each fund he or she oversees, and (y) each director’s aggregate beneficial ownership in all funds the director oversees within the fund family. The SEC’s original proposal would have required disclosure of exact dollar amounts (rather than ranges) of record (rather than beneficial) ownership.

(iii) Information about directors that may raise concerns of conflicts of interest.

Under the new amendments, funds will be required to disclose in their SAI and in their proxy statement any positions, interests, transactions and relationships of directors and their immediate family members with the fund and persons related to the fund.8

The SEC modified its original proposals with respect to the conflicts disclosure requirements, in response to many comments that it was being overly broad and too burdensome. As adopted, interested directors are excluded from the conflicts of interest disclosure in both the SAI and in the proxy statement. Also, the scope of "immediate family members" is narrowed to include only a director’s spouse, children residing in the director’s household and dependents of the director.

The conflict of interest disclosure provisions do not require a fund to disclose "routine, retail transactions and relationships, such as a credit card or bank or brokerage account, unless the director is accorded special treatment."9

Also, the SEC adopted, as proposed, a five-year time period for disclosure of positions and interests of directors and immediate family members in the proxy statements for the election of directors, but only a two-year time period for similar disclosure in the SAI.

The SEC adopted a $60,000 threshold for disclosure of interests, transactions and relationships, rather than a "materiality" standard as proposed. However, the Adopting Release cautions that certain conflicts may need to be disclosed regardless of dollar amounts, due to general anti-fraud concerns; for example, a transaction between a director and a fund’s investment adviser may be required to be disclosed regardless of the dollar amount involved, "if the terms and conditions of the transaction are not comparable to those that would have been negotiated at ‘arms’ length’ in similar circumstances."10

(iv) Information about the board’s role in governing the fund.

The SEC adopted, as proposed, disclosure requirements in proxy statements and SAIs relating to the committees of a fund’s board of directors, and a requirement to disclose in the SAI the board’s basis for approving the fund’s existing investment advisory contract.

All new registration statements and post-effective amendments that are annual updates to effective registration statements, proxy statements for the election of directors and annual reports to shareholders filed on or after January 31, 2002 must comply with the various disclosure amendments.

C. Other Changes

As part of its independent director initiative, the SEC took the following additional measures:

(i) Adopted Rule 2a19-3 under the 1940 Act.

This new Rule prevents qualified individuals from being unnecessarily disqualified from serving as independent directors solely because they own shares of an index fund that invests in the securities of the fund’s investment adviser or principal underwriter, or their controlling persons. Rule 2a19-3 is available only if the owned fund’s investment objective is to replicate the performance of one or more "broad-based" indices.11

Persons may begin to rely on Rule 2a19-3 as of February 15, 2001.

In a related matter, the SEC rescinded Rule 2a19-1 under the 1940 Act; this Rule became unnecessary in light of the Gramm-Leach-Bliley Act’s amendment of Section 2(a)(19) of the 1940 Act to provide that no person can be an independent director if he or she is, or is affiliated with, a registered broker-dealer. The rescission is effective as of May 12, 2001.

(ii) Amended Rule 17d-1(d) under the 1940 Act.

This amended Rule permits funds to purchase "errors and omissions" joint insurance policies for their officers and directors, but the exemption is available only if the joint insurance policy does not exclude coverage for litigation between the investment adviser and the independent directors. The purpose of this amendment is to allow the independent directors to carry out their duties without fear of being entangled in a costly legal dispute with fund management.

The compliance date for the insurance coverage requirement is July 1, 2002.

(iii) Amended Rule 31a-2 under the 1940 Act.

This amended Rule requires funds to preserve for a period of six years any record of:

  1. the initial determination that a director qualifies as an independent director;
  2. each subsequent determination of whether the director continues to qualify as an independent director; and
  3. the determination that any person who is acting as legal counsel to the independent directors is an independent legal counsel.12

The compliance date for recordkeeping in accordance with Rule 31a-2 is July 1, 2002.

(iv) Adopted Rule 10e-1 under the 1940 Act.

This new Rule temporarily suspends the independent director minimum percentage requirements if a fund falls below a required percentage due to an independent director's death or resignation. A fund now will have 90 days to be in compliance if the board can fill a director vacancy, or 150 days if a shareholder vote is required to fill a vacancy. These time periods have been extended from the SEC’s original proposal.

Persons may begin to rely on Rule 10e-1 as of February 15, 2001.

(v) Adopted Rule 32a-4 under the 1940 Act.

This new Rule exempts funds from the requirement that shareholders ratify or reject the directors' selection of an independent public accountant, if the fund establishes an audit committee composed entirely of independent directors. The SEC stated that Rule 32a-4 was enacted because shareholder ratification of accountants "has become largely perfunctory."13

Under Rule 32a-4, a fund is exempt from having to seek shareholder approval of its independent public accountants, if:

  1. the fund establishes an audit committee composed solely of independent directors that oversees the fund’s accounting and auditing processes;
  2. the fund's board of directors adopts an audit committee charter setting forth the committee's structure, duties, powers and methods of operation, or sets out similar provisions in the fund's charter or bylaws; and
  3. the fund maintains a copy of such an audit committee charter (and any amendments thereto). 14

Persons may begin to rely on Rule 32a-4 as of February 15, 2001.

Conclusion

As the SEC succinctly states:

"Together, these new rules and amendments are designed to reaffirm the important role that independent directors play in protecting fund investors, strengthen their hand in dealing with fund management, reinforce their independence, and provide investors with greater information to assess the directors' independence."15

We welcome the opportunity to discuss how Cadwalader may assist you during the implementation of the new fund governance rules.

Footnotes

1 Role of Independent Directors of Investment Companies, Release Nos. 33-7932, 34-43786, IC-24816 (January 2, 2001) (the "Adopting Release"). The Adopting Release is available online at http://www.sec.gov/rules/final/34-43786.htm.

2 The ten Exemptive Rules affected are: (i) Rule 10f-3 (permitting funds to purchase securities in a primary offering when an affiliated broker-dealer is a member of the underwriting syndicate); (ii) Rule 12b-1 (permitting use of fund assets to pay distribution expenses); (iii) Rule 15a-4(b)(2) (permitting fund boards to approve interim advisory contracts without shareholder approval where the adviser or a controlling person receives a benefit in connection with the assignment of the prior contract); (iv) Rule 17a-7 (permitting securities transactions between a fund and another client of the fund's adviser); (v) Rule 17a-8 (permitting mergers between certain affiliated funds); (vi) Rule 17d-1(d)(7) (permitting funds and their affiliates to purchase joint liability insurance policies); (vii) Rule 17e-1 (specifying conditions under which funds may pay commissions to affiliated brokers in connection with the sale of securities on an exchange); (viii) Rule 17g-1(j) (permitting funds to maintain joint insured bonds); (ix) Rule 18f-3 (permitting funds to issue multiple classes of voting stock); and (x) Rule 23c-3 (permitting the operation of interval funds by enabling closed-end funds to repurchase their shares from investors). It is estimated that over 90% of all funds rely on one or more of the Exemptive Rules in conducting their operations.

See Role of Independent Directors of Investment Companies, Investment Company Act Release No. 24082, n.253 (October 14, 1999) (the "Proposing Release").

3 Adopting Release, supra note 1, at n. 30.

4 Rule 0-1(a)(6)(i)(A).

5 Proposing Release, supra note 2, at n. 97.

6 Rule 0-1(a)(6)(iii).

7 Adopting Release, supra note 1, at n.71

8 Persons "related to the fund" include the fund’s officers, investment adviser and principal underwriter, as well as funds having the same investment adviser or principal underwriter, and officers and control persons of any of the foregoing, but does not typically include the fund’s administrator.

9 The SEC clarified that this extends to residential mortgages and insurance policies. See Adopting Release, supra note 1, at n.99

10 Adopting Release, supra note 1, at p.14.

11 Id., at n. 66.

12.Id., at n. 105.

13 Id., at p.8.

14 Id., at nn. 60-63.

15.Id., at p.4.

The content of this article is intended to provide a general guide to the subject matter. Specialist advice should be sought about your specific circumstances.