Investment Company and Investment Advisers Act Developments
On October 13, 1999, the Securities and Exchange Commission ("SEC") voted to propose a package of new rules and rule changes under the Investment Company Act of 1940 ("Investment Company Act") (please see endnote 1). It also voted to issue a related interpretive release containing staff views on various issues involving independent directors. (please see endnote 2) The releases seek to increase the independence and effectiveness of independent directors of investment companies and to expand disclosure of the role of fund directors and potential conflicts of interest on their part.
Rule Proposals
The proposed rule changes would require that independent directors constitute at least a majority of the board; that they nominate any new independent directors; and that their legal counsel be independent from the fund and related entities. The rules would also require extensive new disclosures about all fund directors and their close family members. Other proposed amendments would ease disqualification standards regarding directors’ affiliations with broker-dealers and their index fund holdings; expand directors’ insurance to cover lawsuits between directors and a fund’s adviser; encourage independent audit committees; and require funds to keep records of their determinations of directors’ independence.
Interpretive Release
The accompanying interpretive release (1) clarifies the staff’s position on "material business or professional relationships" that might cause the SEC to issue an order disqualifying an independent director; (2) states that compensating directors for acts in their official capacity is not a joint transaction requiring prior SEC approval; (3) creates a rebuttable presumption that a fund may advance independent directors’ legal fees; and (4) allows directors to be compensated with fund shares if a fixed value is first assigned to their services.
Comments on the rule proposals are due ninety days after publication in the Federal Register, which the SEC anticipates will be January 28, 2000. The views in the interpretive release are effective immediately. A brief summary of both releases follows.
RULE PROPOSALS
The proposed new rules and rule changes largely grow out of a set of recommendations made at the SEC’s February 1999 roundtable on the role of independent directors, (please see endnote 3) and also draw upon a recent report of the Investment Company Institute ("ICI") recommending best practices for funds and their boards. (please see endnote 4) The SEC requested comment on whether to adopt additional best practices from the ICI report.
The proposals would add several requirements to each of ten commonly used exemptive rules that the SEC views as relying on boards to oversee potential conflicts of interest, including rule 12b-1. Thus, these requirements would apply only to funds that rely on these rules.
Majority of Independent Directors.
Independent directors would have to constitute at least a majority of the board. If an independent director dies, resigns, or is disqualified, new rule 10e-1 would allow the time for the fund to replace him to be extended from 30 days to 60 days, or from 60 days to 150 days, if a shareholder vote is needed. The SEC requested comment on whether it should adopt a two-thirds super-majority requirement. The SEC stated that it would expect to allow a one-year delay for funds to come into compliance with this requirement.
Selection and Nomination.
The proposed changes would require new independent directors to be selected and nominated by incumbent independent directors, not the fund’s investment adviser – a requirement already found in rule 12b-1. Where the standard would conflict with state law, the independent directors could act as a nominating committee presenting recommendations to the full board. Shareholders’ ability to nominate independent directors would not be affected.
Independent Legal Counsel.
Legal counsel to independent directors would not be allowed to have represented fund management, close affiliates (including advisers, sub-advisers, principal underwriters, and fund administrators) or their control persons within the previous two fiscal years (but they could represent the fund itself). An exception would allow directors to determine that minor representations and indirect conflicts were not material to counsel’s impartiality.
For all funds, the proposal would require:
Disclosure about Fund Directors.
Funds would be required to disclose extensive new data about the board’s role in fund operations, the identity and business experience of fund directors, the number of fund shares they own, and their potential conflicts of interest. Many disclosures now required in proxy statements for director elections would be expanded and added to the Statement of Additional Information ("SAI"). Basic information about directors’ identity and their key relationships would also appear in the fund’s annual report. The disclosures are meant both to help shareholders and to alert SEC staff to situations that might warrant further inquiry.
Basic Information.
Basic information about directors’ identity, background and other offices and directorships would be added to the annual report and the SAI, on the theory that shareholders rarely receive proxy statements. The current disclosure item on the number of investment companies overseen would be changed to the number of portfolios overseen.Shareholdings.
SAIs and proxy statements would be required to disclose directors’ shareholdings in funds in the same complex.Conflicts of Interest.
The rules would add extensive conflicts disclosure to the SAI and expand disclosures of directors’ positions, interests, transactions and relationships currently required in the proxy rules to (1) cover immediate family members of directors, including step-, in-law, and adoptive relationships; (2) expand the list of fund-related entities with which relationships must be disclosed; and (3) require disclosure of material direct or indirect interests of directors and their families in fund-related entities, or in transactions with related entities. Routine retail relationships would not require disclosure unless the director or family member received special treatment. The SEC requested comment on whether a percent or dollar minimum threshold should be met before disclosure is required.Other Disclosures.
The rules would also: require disclosure of cross-directorships; add to the SAI disclosures on standing committees of the board and on the board’s basis for approving the advisory contract that now appear in proxy statements; and require interested and independent directors to be discussed in separate sections or tables where possible.Compliance Date.
After the rules take effect, these disclosures would be required in all new registration statements, annual updates to effective statements, proxy statements for director election, and shareholder reports.Other Amendments.
The proposals would also:
- Add new rule 2a19-3, exempting an independent director from being disqualified solely by virtue of investing in an index fund that holds shares of the fund’s adviser or other affiliates, if those shares make up no more than 5% of the index, and amend rule 2a19-1 to increase the number of broker-dealer affiliated directors allowed on a board from a minority to no more than half;
- Require that joint "errors and omissions" insurance policies relying on rule 17d-1(d)(7) cover lawsuits between independent directors and a fund’s adviser;
- Add new rule 32a-4, exempting funds with audit committees composed solely of independent directors from the requirement of shareholder approval of the fund’s auditor; and
- Require funds to keep records of their assessments of the independence of their directors.
INTERPRETIVE RELEASE
The interpretive release publishes the views of the staff on several issues involving independent directors of investment companies.
Disqualifying Material Business or Professional Relationships.
The release provides guidance on when a director might be considered to have a "material business or professional relationship" that could cause the SEC to issue an order disqualifying a director from being independent under Investment Company Act § 2(a)(19). The relevant circumstances include material positions or transactions with "specified entities," including a fund, its adviser, its principal underwriter, funds with the same adviser or underwriter, or control persons or principal executive officers of any of the foregoing. Potentially disqualifying positions could include any position with a specified entity within the last two years that involved significant responsibility, compensation, or benefits. Working as portfolio manager of the fund or as an employee of a holding company of the fund’s adviser could be disqualifying, but directorship of other funds managed by the same adviser would not. Inappropriate transactions could include proposed transactions and positions with a specified entity. Whether they were disqualifying would depend on whether they involved substantial benefit to the director: a director could hold an advisory or brokerage account with the fund’s advisor if he received no special treatment, such as allocation of shares in "hot" initial public offerings.
Directors’ Expenses.
The release states that directors’ actions in their capacity as directors are not "joint transactions" for purposes of Section 17(d) of the Investment Company Act and Rule 17d-1. Therefore, fund assets may be used to pay director salaries, board meeting expenses, proxy expenses (even in contested elections), and directors’ counsel’s fees without seeking prior SEC approval.
Indemnification of Directors’ Legal Fees.
The release develops a recent no-action position on the circumstances in which it is appropriate for independent, non-party directors or independent counsel to have a reasonable belief that directors have not engaged in disabling conduct and thus may receive indemnification consistent with Section 17(h) of the Investment Company Act, which prevents funds from indemnifying directors for deliberate, reckless, or grossly negligent misconduct. (please see endnote 5) Under this position, the directors or counsel should employ a rebuttable presumption that directors, acting in their capacities as directors, did not engage in disqualifying conduct.
Compensation with Fund Shares.
In an effort to encourage funds to compensate their directors with fund shares, the release states that the practice does not violate Section 22(g) of the Investment Company Act if a fixed value is assigned to directors’ services in advance, so that they do not receive discounted shares.
The SEC’s Role in Disputes between Directors and Fund Management.
Responding to criticism of the SEC’s role in disputes between independent directors and fund management, the release also states that the public should not infer inaction from SEC silence and notes that the SEC’s role is to administer the securities laws, not to provide mediation.
If you would like copies of the releases or have any questions, please contact Marianne K. Smythe, Jeremy N. Rubenstein, Robert G. Bagnall or Erika K. Singer.
This letter is for general informational purposes only and does not represent our legal advice as to any particular set of facts, nor does this letter represent any undertaking to keep recipients advised as to all relevant legal developments.
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