by John M. Baker, Esquire
On June 24, 1999, the Investment Company Institute (ICI) Advisory Group on Best Practices for Fund Directors released its report on improving fund governance, "Enhancing a Culture of Independence and Effectiveness." The report follows more than a year of high-
profile Securities and Exchange Commission (SEC) interest in the role of investment company directors, and it precedes anticipated SEC rulemaking in this area. On July 7, 1999, the ICI’s Board of Governors strongly endorsed the report and recommended that all ICI management investment company members take appropriate actions to implement the practices recommended in the report as soon as practicable.
The report’s most significant recommendations are intended to increase the independence of fund boards. One recommendation requires at least two-thirds of all investment company directors to be independent. This would set a higher standard of independence than existing law by excluding former officers and directors of a fund’s investment adviser, principal underwriter, or certain other affiliates from service as independent directors of the fund. A former director or officer of an investment adviser or principal underwriter still could serve as an independent director for Investment Company Act of 1940 (1940 Act) purposes, but he or she would be considered affiliated for purposes of the report’s recommendations.
The Advisory Group recognized that while investment company boards that meet these standards are not uncommon, compliance is far from universal. In order to comply, many fund boards will have to either remove affiliated directors or add independent directors. Such changes are difficult, especially if a shareholder vote is required. Section 16(a) of the 1940 Act requires that new directors be elected at a shareholder meeting, unless immediately after filling a board vacancy at least two-thirds of the directors have been elected by shareholder vote. It is likely that many of the funds that embrace the Advisory Group standards will do so gradually, to minimize these issues. Having more independent directors can also increase director compensation costs, which may be an issue for many smaller funds.
The report also recommends that independent directors have qualified investment company counsel who is independent from the investment adviser and the fund’s other service providers. Although the Advisory Group does contemplate that counsel for the independent directors could also represent the fund and do some limited work for the investment adviser or other service providers, some smaller funds currently have only one law firm to represent all parties and are expected to object to the expense of additional lawyers.
The SEC’s focus on fund governance dates back to SEC Chairman Arthur Levitt’s speech at the ICI’s General Membership Meeting on May 15, 1998. In this speech, Chairman Levitt announced plans to hold a national roundtable meeting on fund governance. The SEC Roundtable on the Role of Independent Investment Company Directors was held on February 23 and 24, 1999. From these sessions, a major SEC initiative developed to improve mutual fund governance, which Chairman Levitt reported at the ICI Mutual Funds and Investment Management Conference on March 22, 1999. [See "New Rules and Best Practices Forthcoming for Independent Directors," Fund Alert Special Edition (Apr. 1999)]
In response to Chairman Levitt’s initiative, the ICI promptly formed an Advisory Group on Best Practices for Fund Directors. The Advisory Group’s mission was to identify the best practices used by investment company boards to enhance the culture of independence and effectiveness, and to recommend those practices that should be considered for adoption by all fund boards. Chairman Levitt commended the ICI for moving rapidly in response to his call for action. The SEC will consider rule proposals in the near future to address fund governance issues, including those not addressed in the ICI report.
The ICI Advisory Group consisted of three experienced independent fund directors and three senior executives of major fund management organizations who serve as affiliated directors of the funds managed by their organizations. The group was chaired by John J. Brennan, Chairman and CEO, The Vanguard Group, and a member of the board of directors of each of its mutual funds. Mr. Brennan is also Chairman of the Board of Governors of the ICI. The Advisory Group’s other members included Dawn-Marie Driscoll, Independent Director, The Scudder Kemper Mutual Funds; Paul G. Haaga, Jr., Executive Vice President and Director, Capital Research and Management Company; Dr. Manuel H. Johnson, Independent Director, The Morgan Stanley Dean Witter Family of Funds; William M. Lyons, President and COO, American Century Companies, Inc.; and Gerald C. McDonough, Independent Trustee, The Fidelity Funds.
SEC Reaction
As noted above, the SEC praised the Advisory Group for its report and stated that it will consider rule proposals in the near future to address fund governance issues, including those not addressed in the report. In addition, Chairman Levitt has already said that he would like to inform shareholders more about directors, so that they can judge the independence of fund directors themselves. It is likely that these reports would include the existence of any prior or ongoing relationships with management, directors’ holdings in the funds they oversee, the number of portfolios under a director’s supervision, and the length of time the director has been there. This disclosure would be made in the fund’s statement of additional information.
The SEC is also considering amending 1940 Act rules to require that funds keep records that reflect the basis for initially determining and periodically confirming that independent directors are not "interested persons" as defined under
the Act. Paul Roye, Director of the Division of Investment Management, has also commented that the SEC is considering offering interpretive guidance on various issues of interest to independent directors. These issues are expected to include the circumstances under which the SEC might exercise its authority to treat a director as an "interested person"; an analysis of why independent director actions do not constitute "joint transactions" under 1940 Act Rule 17d-1; and the standards that determine when a fund may indemnify or advance legal fees to independent directors. No timetable for these developments has been provided, but they are expected to occur relatively soon.
Text of Recommendations
The ICI Advisory Group report recommends the following practices for consideration by all investment company boards of directors. A mutual fund will be able to state that it is in full compliance with the industry’s independent director best practices only if all of the requirements set forth below are met. The Advisory Group report recommends that:
1. At least two-thirds of the directors of all investment companies be independent directors.
2. Former officers or directors of a fund’s investment adviser, principal underwriter, or certain other affiliates not serve as independent directors of the fund.
3. Independent directors be selected and nominated by the incumbent independent directors.
4. Independent directors establish the appropriate compensation for serving on fund boards.
5. Fund directors invest in funds on whose boards they serve.
6. (i) Independent directors have qualified investment company counsel who is independent from the investment adviser and the fund’s other service providers; and (ii) independent directors have express authority to consult with the fund’s independent auditors or other experts, as appropriate, when faced with issues that they believe require special expertise.
7. Independent directors complete an annual questionnaire detailing business, financial, and family relationships, if any, with the adviser, principal underwriter, other services providers, and their affiliates.
8. (i) Investment company boards establish Audit Committees composed entirely of independent directors; (ii) the Audit Committee meets with the fund’s independent auditors at least once a year outside the presence of management representatives; (iii) the Audit Committee secures from the auditor an annual representation of its independence from management; and (iv) the Audit Committee has a written charter that spells out its duties and powers.
9. Independent directors meet separately from management in connection with their consideration of the fund’s advisory and underwriting contracts and otherwise, as they deem appropriate.
10. Independent directors designate at least one "lead" independent director.
11. Fund boards obtain directors’ and officers’/ errors and omissions (D&O/E&O) insurance coverage and/or indemnification from the fund that is adequate to ensure the independence and effectiveness of independent directors.
12. Investment company boards of directors generally be organized either as a unitary board for all the funds in a complex or as cluster boards for groups of funds within a complex, rather than as separate boards for each individual fund.
13. Fund boards adopt policies on retirement of directors.
14. Fund directors evaluate periodically the board’s effectiveness.
15. New fund directors receive appropriate orientation and that all fund directors keep abreast of industry and regulatory developments.
John M. Baker is an Of Counsel in Securities and Investment Company Department of Stradley Ronon Stevens & Young, LLP. Mr. Baker resides in the firm’s Washington, DC office. He can be reached at (202) 261- 3512 or jbaker@stradley.com
Information contained in this article should not be construed as legal advice or opinion, or should not be a substitute for legal counsel. This material is provided for informational and educational purposes.