Investment Company Governance, 39390-39410 [05-13314]
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39390
Federal Register / Vol. 70, No. 129 / Thursday, July 7, 2005 / Rules and Regulations
SECURITIES AND EXCHANGE
COMMISSION
amendments to the Exemptive Rules
require no modification.
17 CFR Part 270
I. Background
[Release No. IC–26985; File No. S7–03–04]
RIN 3235–AJ05
Investment Company Governance
Securities and Exchange
Commission.
ACTION: Commission response to remand
by court of appeals.
AGENCY:
SUMMARY: The Commission has
considered further its adoption of
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
reconsideration responds to a decision
by the United States Court of Appeals
for the District of Columbia Circuit
remanding to us for further
consideration two issues raised by the
rulemaking.
FOR FURTHER INFORMATION CONTACT:
Penelope Saltzman, Branch Chief, or C.
Hunter Jones, Assistant Director, Office
of Regulatory Policy, (202) 551–6792,
Division of Investment Management,
Securities and Exchange Commission,
100 F Street, NE., Washington, DC
20549.
SUPPLEMENTARY INFORMATION: In
Chamber of Commerce of the United
States of America v. Securities and
Exchange Commission, the United
States Court of Appeals for the District
of Columbia Circuit remanded to us, in
part, for additional consideration certain
amendments we adopted last year to ten
rules under the Investment Company
Act of 1940 (‘‘Investment Company Act’’
or ‘‘Act’’).1 The amendments are
applicable to funds that rely on any of
ten exemptive rules the Commission has
adopted under the Investment Company
Act (‘‘Exemptive Rules’’).2 The
amendments were 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. As the
Court directed, the Commission has
carefully considered the issues
identified by the Court in remanding
this matter to us. We have determined,
in light of that consideration, that the
1 Chamber of Commerce of the United States of
America v. SEC, No. 04–1300, slip op. (D.C. Cir.
June 21, 2005) (‘‘Slip Opinion’’).
2 Investment Company Governance, Investment
Company Act Release No. 26520 (July 27, 2004) [69
FR 46378 (Aug. 2, 2004)] (‘‘Adopting Release’’). The
Exemptive Rules are listed in the Adopting Release
at footnote 9.
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On July 27, 2004, the Commission
adopted amendments to the Exemptive
Rules under the Investment Company
Act to require funds that rely on one or
more of those rules to adopt certain
governance practices.3 Among other
things, the amendments added two
conditions for relying on the Exemptive
Rules. The amendments require that, if
a fund relies on at least one of the
Exemptive Rules to engage in certain
transactions otherwise prohibited by the
Act, the fund must have a board of
directors with (i) no less than 75 percent
independent directors,4 and (ii) a
chairman who is an independent
director. We adopted the amendments
in the wake of a troubling series of
enforcement actions involving late
trading, inappropriate market timing
activities, and misuse of nonpublic
information about fund portfolios.5
The two new conditions were
challenged by the Chamber of
Commerce, which submitted a petition
for review to the United States Court of
Appeals for the District of Columbia
Circuit. In that case, the Chamber of
Commerce asserted that the Commission
(i) lacked authority to adopt the
amendments, and (ii) violated the
Administrative Procedure Act
(‘‘APA’’).6
On June 21, 2005, the Court of
Appeals issued its decision that ‘‘the
Commission did not exceed its statutory
authority in adopting the two
conditions, and the Commission’s
rationales for the two conditions satisfy
the APA.’’ 7 The Court noted the broad
authority granted to the Commission to
exempt transactions ‘‘subject only to the
public interest and the purposes of the
[Act].’’ 8 In addition, the Court found
that our actions were reasonable in light
of the significant problems we identified
with mutual funds that have arisen as a
result of serious conflicts of interest.
The Court, however, remanded to the
Commission for our consideration two
deficiencies that it identified in the
rulemaking. First, the Court held that, in
connection with our statutory obligation
to consider whether the conditions will
Release, supra note 2.
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 section 2(a)(19) of the Act [15 U.S.C. 80a–
2(a)(19)].
5 See Adopting Release, supra note 2, at nn.5–6
and accompanying text.
6 5 U.S.C. 551 et seq.
7 Slip Opinion, supra note 1, at 2.
8 Id. at 7.
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3 Adopting
4 In
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promote efficiency, competition and
capital formation, we did not adequately
consider costs associated with the 75
percent independent board and the
independent chairman conditions.
Second, the Court stated that we did not
give adequate consideration to an
alternative discussed by the two
Commissioners who dissented from the
adoption of the rules (‘‘disclosure
alternative’’). The Court did not vacate
the rule amendments, however, and
they remain in effect.9
II. Introduction
In this Release, we further consider
and address the two issues raised by the
Court’s remand order. As a threshold
matter, we consider whether it is
necessary to engage in additional factgathering to implement the Court’s
remand order, or otherwise engage in
further notice and comment
procedures.10 The existing record,
which was before the Commission at the
time the amendments were adopted,
was developed through full notice and
comment procedures. The notice
initiating those procedures and
soliciting public comment proposed two
conditions for exemption that were
substantially identical to the conditions
that we adopted and that are supported
by our additional discussion in this
Release. Although the Court held that
we ultimately failed in our Adopting
Release adequately to address the issues
identified by the Court in its opinion,
we had specifically sought and received
comment on the costs associated with
the two conditions and had considered
those costs at the time of the initial
rulemaking. We further note that the
original notice solicited comment on
9 See id. at 19 (ordering the matter ‘‘remanded’’
and citing Fox Television Stations, Inc. v. FCC, 280
F.3d 1027, 1048–49 (D.C. Cir. 2002) (explaining
reasons for remanding a rulemaking without
vacating) and Allied Signal, Inc. v. U.S. Nuclear
Regulatory Comm’n, 988 F.2d 146, 150–51 (D.C. Cir.
1993) (same)).
10 Where, as here, a court does not specify a
required procedure, the agency is free on remand
to determine whether supplemental fact-gathering
is necessary. Furthermore, if the existing record is
a sufficient base on which to address on remand the
court-identified deficiencies, additional notice and
comment procedures are not required. See Sierra
Club v. EPA, 325 F.3d 374, 382 (D.C. Cir. 2003)
(following the ‘‘usual rule’’ by remanding ‘‘for
further explanation, though not necessarily for
further notice-and-comment rulemaking’’); National
Grain and Feed Ass’n, Inc. v. OSHA, 903 F.2d 308,
310–11 (5th Cir. 1990) (leaving ‘‘the agency free on
remand to determine whether supplemental factgathering is necessary for correction of the
perceived error or deficiency.’’). See also AT&T
Wireless Servs., Inc. v. FCC, 365 F.3d 1095, 1103
(D.C. Cir. 2004) (upholding after remand additional
explanation of prior FCC decision where FCC found
on remand that ‘‘the existing record was ‘a
sufficiently adequate base on which to rest the
Commission’s decision * * *’’).
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whether there were alternatives that
would serve the same or similar
purposes, and elicited comment on the
disclosure alternative.11 We find that
the information in the existing record,
together with publicly available
information upon which we may rely, is
a sufficient base on which to rest the
Commission’s consideration of the
deficiencies identified by the Court.
Thus, our consideration and discussion
in this Release of the two issues relies
upon that record and previously
available public information, and we
have determined that it is not necessary
to engage in further notice and comment
procedures in order to follow the
Court’s direction on remand.
Moreover, engaging in further notice
and comment procedures is not only
unnecessary, it risks significant harm to
investors without significant
corresponding benefits, given the
adequacy of the information currently
available upon which we may rely. The
amendments to the Exemptive Rules are
the centerpiece of a broader regulatory
effort to restore investor confidence in
the mutual fund industry in the wake of
the discovery of serious wrongdoing at
many of the nation’s largest fund
complexes and by officials at the highest
levels of those complexes. Fund
managers acted in their own interests
rather than in the interests of fund
investors (which they are required to
do), resulting in substantial investor
losses that were well documented at the
time we adopted the amendments.
Further, subsequent events, although
they do not form the basis of our action,
have shown that the level of
wrongdoing, and the corresponding
investor losses, were in fact significantly
greater than was known at that time. By
acting promptly, we hope to bolster
investor confidence, resolve any
uncertainties associated with the
remand, and ensure that investors
receive the protections afforded by the
amendments without delay.12 It is
11 See Investment Company Governance,
Investment Company Act Release No. 26323 (Jan.
15, 2004) [69 FR 3472 (Jan. 23, 2004)] (‘‘Proposing
Release’’), at text preceding n.32; see also Comment
Letter of the Financial Services Roundtable, File
No. S7–03–04 (Mar. 10, 2004) (‘‘[I]nvestors will be
able to express their views on this [independent
chairman] issue, given clear and appropriate
disclosure. * * * Investors for whom this issue is
a priority can direct their investments to those
funds.’’); Comment Letter of Greenspring Fund,
Incorporated, File No. S7–03–04 (June 17, 2004)
(‘‘Greater disclosure of relevant information would
allow shareholders to make better informed
decisions. If an independent Chairman is desirable
in the eyes of some investors, then make that
information readily accessible.’’).
12 As noted above, the Court, while remanding a
portion of the rulemaking for our consideration, did
not vacate the rule amendments. See Slip Opinion,
supra note 1, at 19.
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important that we avoid postponement
of the compliance date and the
attendant potential harm to investors
and the market that would result.13
Because Chairman Donaldson was
scheduled to leave the Commission on
June 30, 2005, and his replacement,
although announced by the President,
had not been formally nominated by
him or confirmed by the Senate, we
considered it important to act on this
important matter no later than the time
of our open meeting scheduled for June
29, 2005. In adopting the amendments
to the Exemptive Rules, we carefully
considered the issues presented by the
rulemaking and reviewed the extensive
record before the Commission. This is
the last opportunity to bring the
collective judgment and learning of all
of us, who have spent the last year and
a half thinking about the issues raised
in this rulemaking, to bear on the
important questions presented to us by
the Court. Given our unique familiarity
with these matters, we think it is both
important and appropriate for the same
five of us to consider the issues raised
by the Court on remand, especially
given the potential harm that may result
from delay in resolving this matter.
We take very seriously and act with
the utmost respect for the Court of
Appeals’ admonition that we failed
adequately to consider the costs
imposed upon funds by the two
challenged conditions, and failed to
consider the disclosure alternative. Our
determination to act promptly in no way
diminishes our obligation to make a
deliberate and careful consideration of
the issues raised by the Court. We have
undertaken to address those issues upon
remand promptly because we are
convinced that we can do so with the
thoroughness and careful consideration
required by the Court’s direction to us,
and without the sacrifice to investor
protection that delay would risk.
Because we have previously sought and
received comment, the Commission has
a significant foundation from which to
consider the issues remanded by the
Court. In light of that experience, and
because the existing record and other
publicly available information allow us
to undertake the additional
consideration required, we have
determined that we can fully discharge
our responsibilities within the time
necessary to allow participation by the
same group of Commissioners that
adopted the amendments to the
Exemptive Rules. Our failure to act at
13 See Adopting Release, supra note 2, at Section
IV (funds relying on Exemptive Rules must begin
complying with the Exemptive Rule amendments
after January 15, 2006).
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this time, moreover, risks the creation of
significant uncertainties and potential
harm to investors that would not, in our
judgment, be in the public interest.14
III. Discussion
A. Costs Resulting From Exemptive Rule
Amendments
In the release proposing the
amendments to the Exemptive Rules, we
discussed and solicited comment on the
costs and benefits of those rule
amendments, and whether they would
promote efficiency, competition and
capital formation.15 In the Adopting
Release, we again discussed the costs
and benefits of the amendments, and
whether they would promote efficiency,
competition and capital formation.16
In this Release, we reexamine the
costs of the Exemptive Rule
amendments in the two areas identified
by the Court: (i) The costs to funds of
complying with the condition that at
least 75 percent of a fund’s directors be
independent; and (ii) the costs to funds
of complying with the condition that the
chairman be an independent director,
particularly the costs of possible
additional staff that the independent
chairman might hire.17
1. Board Composition
The amendments will impose
additional costs on funds that rely on
any of the Exemptive Rules by requiring
that independent directors constitute at
least 75 percent of the fund board or, if
the fund board has only three directors,
that all but one director be independent.
As discussed in the Adopting Release,
we have estimated that nearly 60
percent of all funds currently meet the
75 percent condition.18 A fund that does
not already meet this condition may
come into compliance with the 75
percent condition by: (i) Decreasing the
size of its board and allowing some
14 Even prior to our having issued this Release,
there have been reports that additional legal
proceedings may result from our action today.
Accordingly, we are instructing our Office of the
General Counsel to take such action as it considers
appropriate to respond to any proceedings relating
to this rulemaking.
15 Proposing Release, supra note 11, at Sections
V and VII.
16 Adopting Release, supra note 2, at Sections VI
and VIII. As the Court noted, section 2(c) of the
Investment Company Act [15 U.S.C. 80a–2(c)]
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. Slip Opinion, supra note 1, at 12–13.
17 In preparing estimates in this Release, we rely
where appropriate on data that can be obtained or
confirmed through publicly available filings under
the Federal securities laws.
18 See Adopting Release, supra note 2, at n.78.
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interested directors to resign; (ii)
appointing new independent directors
either to replace interested directors
(maintaining the current size of its
board) or to increase the current size of
its board; 19 or (iii) electing new
independent directors either to replace
interested directors (maintaining the
current size of its board) or to increase
the current size of its board.20 In order
to provide funds with maximum
flexibility, we did not specify which
option they must select.
In the Adopting Release, we stated
that ‘‘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.’’ 21 The Court of Appeals
noted, however, that ‘‘[t]hat particular
difficulty may mean the Commission
can determine only the range within
which a fund’s cost of compliance will
fall,’’ 22 and directed that the
Commission determine as best it can the
economic implications of the rule.
Based on the record in this matter, as
well as our review of publicly available
information, we have concluded that we
do in fact have a reliable basis upon
which to consider the range of costs
associated with each of the different
ways in which funds may choose to
comply with the 75 percent condition,
as the Court directed.
a. Adding Independent Directors
Funds that elect to add independent
directors in order to meet the 75 percent
condition have two options. They may
replace some interested directors with
independent directors, or they may
19 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)] (board vacancy may be filled by
any legal manner if immediately after filling the
vacancy at least two-thirds of directors have been
elected by fund shareholders).
20 Our description of the three options available
to funds differs slightly from the description in the
Adopting Release. As discussed in greater detail
below, funds will incur costs to add new
independent directors regardless of whether those
new independent directors replace interested
directors or increase the size of the board. Funds’
costs will differ, however, depending on whether
the board can appoint the new independent
directors under section 16(a) of the Act or whether
the fund’s shareholders must approve the new
independent directors. Unlike funds whose boards
can appoint new independent directors, funds that
must obtain shareholder approval for new
independent directors will incur proxy solicitation
expenses.
21 See Adopting Release, supra note 2, at text
accompanying n.80.
22 Slip Opinion, supra note 1, at 15–16 (‘‘That
particular difficulty [of determining aggregate costs]
may mean the Commission can determine only the
range within which a fund’s cost of compliance will
fall, depending upon how it responds to the
condition * * .’’).
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increase the size of the board. Funds
that choose simply to replace interested
directors with independent directors or
that add additional independent
directors and are able to appoint the
new independent directors may incur
three kinds of costs. First, funds may
incur initial and periodic costs of
finding qualified candidates. Second,
funds will incur annual compensation
costs for the new independent directors.
Third, funds could incur additional
annual costs if new independent
directors use additional services of
independent legal counsel.23 Because
smaller fund groups typically provide
less compensation (for overseeing fewer
funds) than larger fund groups (for
overseeing more funds), our
compensation estimates are based on a
range of potential costs.
We understand that a majority of
funds have eight or fewer directors.24
Accordingly, we conclude that most
funds could appoint one or two
independent directors in order to
comply with the 75 percent condition.25
For example, a board with eight
directors could comply with the
condition by replacing one interested
director with an independent director.26
23 We also considered whether funds might incur
additional costs as a result of additional premiums
for directors’ liability insurance. Most policies
covering mutual fund directors’ liability are priced
based principally on the level of risk estimated by
the insurer, on the amount of assets under
management, and on the maximum aggregate limit
of liability covered, rather than on the number of
directors. Given our expectation that
implementation of the rule amendments, with their
effect of strengthening independent oversight of
conflicts of interest, will reduce the risk of
misconduct and ensuing investor losses, the cost of
insuring against such risk should, if anything, be
reduced. In any event, we have concluded that an
increased cost of coverage associated with the two
conditions, if any, will be minimal and will be
adequately covered by the allowances for overhead
and the cushions we have used in considering
costs.
24 See Management Practice Inc. Bulletin: Fund
Directors’ Pay Increases 17% in Smaller Complexes,
8% in Larger (June 2003) (‘‘Boards are getting
smaller with 60% having 8 directors or less.’’)
(available at: https://www.mfgovern.com/);
Management Practice Inc. Bulletin: More Meetings
Means More Pay for Fund Directors (Apr. 2004)
(‘‘April 2004 MPI Bulletin’’) (‘‘Boards are staying
about the same overall size, with a slight decrease
in the number of interested directors, which
facilitates a new 75% independent requirement.’’).
25 A fund that currently relies on any of the
Exemptive Rules would already have a majority of
independent directors on the board. See Role of
Independent Directors of Investment Companies,
Investment Company Act Release No. 24816 (Jan. 2,
2001) [66 FR 3734 (Jan. 16, 2001)].
26 An 8 member board of a fund that relies on at
least one Exemptive Rule currently must have at
least 5 independent directors. By replacing an
interested director with an independent director, 6
out of 8 (75%) would be independent. By replacing
two interested directors with two independent
directors on a 7 member board (which must have
at least 4 independent directors), 6 out of 7 (86%)
would be independent.
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However, we received one comment
from a fund with five directors that
stated it would not want to reduce the
number of interested directors, and
therefore would have to add three new
independent directors in order to meet
the 75 percent condition.27 In light of
this comment, and acting conservatively
so as not to underestimate costs, we
have estimated for purposes of this
discussion that a fund would appoint
three new independent directors.
Based on data from a 2004 survey of
mutual fund directors’ compensation,28
we estimate that the median annual
salary for directors ranges from
$111,500 (for boards that oversee a large
number of funds 29) down to $12,500
(for boards that oversee from 1 to 6
funds). Consistent with the approach
suggested by the Court with respect to
the hiring of additional staff in
connection with the independent
chairman condition, we make the
estimates based upon the potential costs
to an individual fund. Thus, we
estimate the annual compensation cost
per fund for appointing one
independent director could range from
$1593 (for boards that oversee a large
number of funds) to $12,500 (for boards
that oversee only one fund).30
Accordingly, if a fund were to appoint
three independent directors, we
27 See Comment Letter of the Disinterested
Directors of ICAP Funds, Inc., File No. S7–03–04
(Mar. 4, 2004).
28 See April 2004 MPI Bulletin, supra note 24.
The information provided in the Bulletin
‘‘summarizes 2003/4 findings of the Mutual Fund
Directors’’ Compensation and Governance Practices
survey with data drawn from public documents of
290 complexes, representing 1,620 directors/
trustees and the confidential responses of
participating complexes.’’ Thus, the survey may
include compensation information concerning both
independent and interested directors. Because
interested directors generally are compensated by
the adviser, not the fund, we have assumed for
purposes of the estimates that the compensation
reflects annual compensation of independent
directors. This survey is a widely used industry
survey, an earlier version of which was cited by the
dissenting Commissioners in their statement
attached to the Adopting Release. See Adopting
Release, supra note 2, Dissent of Commissioners
Cynthia A. Glassman and Paul S. Atkins, at n.24.
29 For purposes of these estimates, we define
boards that oversee a ‘‘large number’’ of funds as
boards that oversee 70 or more funds. The per fund
estimates we discuss related to these boards are
calculated by basing per fund costs on a board that
oversees 70 funds, which yields greater per fund
costs than using a higher number would.
30 These annual estimates of the cost of one
independent director are based on the following
calculations: ($111,500 ÷ 70 funds = $1593);
($12,500 ÷ 1 fund = $12,500). In considering the
range of costs per fund, we divided the median
salary for a director overseeing a large number of
funds (70 or more) by 70 funds, and the median
salary for a director overseeing a small number of
funds (1 to 6) by 1 fund. The range of funds was
based on data provided in the April 2004 MPI
Bulletin, supra note 24.
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estimate that these annual
compensation costs could range, on a
per fund basis, from $4779 (for boards
that oversee a large number of funds) to
$37,500 (for boards that oversee one
fund).31
We further estimate that the costs to
recruit an independent director may
equal the independent director’s first
year salary.32 This cost may be incurred
initially when the independent directors
are first appointed, and periodically
thereafter when, from time to time, an
independent director is replaced. In our
judgment, we conservatively estimate
that the need to replace a director will,
on average, occur no more often than
once every five years.33 Thus, the initial
per fund cost for recruiting services for
three independent directors could range
from $4779 (for boards that oversee a
large number of funds) to $37,500 (for
boards that oversee one fund).34 Based
on turnover every five years, the annual
cost per fund thereafter to replace
independent directors could range from
$956 to $7500.35
We expect that funds will incur
additional costs because of increased
reliance by new independent directors
on the services of independent legal
counsel. Based upon our experience, we
estimate that, on average, the new
independent directors will use an
additional 30 hours annually of
independent legal counsel services. We
have estimated that the average hourly
rate for an independent counsel is
$300,36 which yields a total cost of
31 These annual estimates of the cost per fund are
based on the following calculations: ($1593 × 3
directors = $4779); ($12,500 × 3 directors =
$37,500).
We note that commenters’ estimated costs of
paying new independent directors ranged from
$4000 to $20,000, which are roughly comparable
with and do not exceed our estimated range. See
Comment Letter of New Alternatives Fund, Inc.,
File No. S7–03–04 (Feb. 9, 2004); Comment Letter
of Independent Directors of Flaherty & Crumrine
Preferred Income Opportunity Fund Inc., File No.
S7–03–04 (Feb. 23, 2004).
32 See, e.g., Andrea Felsted, Headhunters Feel the
Heat in Quality Quest: Shareholder Reaction to
Sainsbury’s Choice of a Chairman-Designate has
Shed a Harsh Light on a Secretive World,
FINANCIAL TIMES, Feb. 21, 2004, at 5. This onetime cost would be shared among the funds that the
director oversees.
33 See, e.g., Management Practice Inc. Bulletin:
Mutual Fund Directors’ Compensation Increases
9% in a Turbulent Year (last modified Oct. 30,
2001) (available at https://www.mfgovern.com/)
(noting that, based on a 2000 survey, ‘‘[s]erving
trustees have a median age of 62 with a median of
10 years of service.’’).
34 See supra note 31.
35 These estimates are based on the following
calculations: ($4779 ÷ 5 = $956); ($37,500 ÷ 5 =
$7500).
36 The $300 per hour estimated billing rate is one
we have used in recent rulemakings. See, e.g.,
Disclosure Regarding Nominating Committee
Functions and Communications Between Security
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$9000 annually, per board. Thus, the
range of costs for additional
independent counsel services could
range from $9000 per fund (for a board
that oversees one fund) to $129 per fund
(for a board that oversees a large number
of funds).37
Estimated total costs per fund. Based
on this data, we estimate that the total
costs in the first year, for funds that
appoint three new independent
directors, could range from $9687 per
fund (for boards that oversee a large
number of funds) to $84,000 per fund
(for boards that oversee one fund).38
Annual costs in subsequent years would
decrease to a range of $5864 per fund
(for boards that oversee a large number
of funds) to $54,000 per fund (for boards
that oversee only one fund).39
Funds that must obtain shareholder
approval for new independent directors
(whether to replace interested directors
or to increase the size of the board) will
incur additional costs of soliciting
proxies from shareholders. We estimate
the average costs of soliciting proxies as
$75,000 per fund.40 If a fund must
obtain shareholder approval for three
new independent directors, the initial
costs to add the directors could range
from $84,687 per fund (for boards that
oversee a large number of funds) to
$159,000 per fund (for boards that
oversee one fund).41 And as discussed
above, costs would decrease in
subsequent years to a range of $5864 per
fund (for boards that oversee a large
number of funds) to $54,000 per fund
(for boards that oversee only one
fund).42
Holders and Boards of Directors, Securities Act
Release No. 8340 (Nov. 24, 2003) [68 FR 69204
(Dec. 11, 2003)] at n.149.
37 These estimates are based on the following
calculations: ($9000 ÷ 1 = $9000); ($9000 ÷ 70 =
$129).
38 These estimates are based on the following
calculations: ($4779 (first year compensation) +
$4779 (recruiting costs) + $129 (independent
counsel costs) = $9687); ($37,500 (first year
compensation) + $37,500 (recruiting costs) + $9000
(independent counsel costs) = $84,000).
39 These estimates are based on the following
calculations: ($4779 (annual compensation) + $956
(recruiting costs) + $129 (independent counsel
costs) = $5864); ($37,500 (annual compensation) +
$7500 (recruiting costs) + $9000 (independent
counsel costs) = $54,000).
40 See Investment Company Mergers, Investment
Company Act Release No. 25666 (July 18, 2002) [67
FR 48512 (July 24, 2002)], at Section V. That cost
could be substantially diminished if a proxy vote
were scheduled to be held during the period on
other matters.
41 These estimates are based on the following
calculations: ($9687 (first year compensation,
recruiting and independent legal counsel costs) +
$75,000 (proxy costs) = $84,687); ($84,000 (first
year compensation, recruiting and independent
legal counsel costs) + $75,000 (proxy costs) =
$159,000).
42 See supra note 39.
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39393
We have also estimated increased
costs to funds to reflect the increased
responsibilities that independent
directors may take on as a result of the
75 percent condition. To reflect this and
other possible cost increases (including
proxy cost increases), we have estimated
that costs of complying with the
condition may today have increased by
as much as 20 percent.43 Accordingly,
we have estimated current first year
costs of the condition for funds in
which the board appoints three new
independent directors. These costs
could range from $11,624 per fund (for
boards that oversee a large number of
funds) to $100,800 per fund (for boards
that oversee one fund).44 We have
further estimated that the current first
year cost for funds that elect three new
independent directors could range from
$101,624 per fund (for boards that
oversee a large number of funds) to
$190,800 per fund (for boards that
oversee one fund).45 Whether the new
independent directors are appointed or
elected, ongoing costs could range from
$7037 per fund (for boards that oversee
a large number of funds) to $64,800 per
fund (for boards that oversee one
fund).46
b. Decreasing Interested Directors
Finally, funds that simply decrease
the size of their boards and allow some
interested directors to resign are likely
to incur, at most, only minimal direct
costs. The decision to reduce the size of
the board and eliminate one or more
interested directors from the board
would likely be made at a previously
scheduled board meeting.47 Because
this option is the simplest of the three
options and imposes the lowest direct
costs, it is likely that many, if not most,
funds will choose to comply with the 75
percent condition by using this
43 As to director compensation, the conservative
nature of this estimate is confirmed by publicly
available information indicating that in 2004,
directors’ compensation increased by 13 percent.
See Management Practice Inc. Bulletin: More
Meetings, More Pay: Fund Directors’ Compensation
Increases 13% as Workload Grows (Apr. 2005)
(available at https://www.mfgovern.com).
44 These estimates are based on the following
calculations: ($9687 × 1.2 = $11,624); ($84,000 × 1.2
= $100,800).
45 These estimates are based on the following
calculations: ($84,687 × 1.2 = $101,624); ($159,000
× 1.2 = $190,800).
46 These estimates are based on the following
calculations: ($5864 × 1.2 = $7037); ($54,000 × 1.2
= $64,800).
47 In the unusual circumstances in which the
interested directors are compensated by the fund
rather than by the fund’s adviser, the termination
of the interested directors could result in a cost
savings for the fund. We understand, however, that
in most cases the fund’s adviser compensates the
interested directors directly.
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option.48 There is the possible nonmonetary cost of the loss of experience
on the board. In other words, having
fewer interested directors on the board
might decrease the expertise of the
board. As we discussed in the Adopting
Release, however, nothing in the
Exemptive Rule amendments would
prohibit interested persons from
participating in board meetings, if the
directors decide to include them in
those meetings.49 Thus we believe that
the reduction in the number of
interested directors will likely result, at
most, in only minimal direct costs.50
2. Independent Chairman
The Exemptive Rule amendments also
require that a fund relying on an
Exemptive Rule have an independent
director serve as chairman of the board.
As we noted in the Adopting Release,
there may be costs associated with the
independent chairman condition, such
as the costs of hiring staff to assist the
chairman in carrying out his or her
responsibilities.51 However, we said
that we had no reliable basis for
estimating those costs. The Court of
Appeals noted that ‘‘[a]lthough the
Commission may not have been able to
estimate the aggregate cost to the mutual
fund industry of additional staff because
it did not know what percentage of
funds with [an] independent chairman
would incur that cost, it readily could
have estimated the cost to an individual
fund.’’ 52 Based on the record in this
matter, as well as a review of publicly
available information, we have
concluded that we do in fact have a
reliable basis for estimating the costs to
an individual fund associated with the
independent chairman condition, as the
48 See, e.g., April 2004 MPI Bulletin, supra note
24 (‘‘Boards stayed about the same size, but the
number of affilaited directors declined as the
preferred method of achieving the required 75%
independent.’’); Comment Letter of the Directors’
Committee of the Investment Company Institute,
File No. S7–03–04 (Mar. 10, 2004) (‘‘While it is our
expectation that most funds would reach this
percentage by asking an interested director to step
down from the board, there are some boards that
will do so by adding an independent director.’’);
Comment Letter of New Alternatives Fund, Inc.,
File No. S7–03–04 (Feb. 9, 2004) (‘‘[I]t is difficult
to find competent directors. An alternative is for the
undersigned founder to resign as a director while
remaining a manager. We could then reach the 75%
requirement.’’).
49 See Adopting Release, supra note 2, at text
following n.50 and at text preceding and following
n.60.
50 It would be impracticable to quantify the
indirect costs of choosing this option. Of course, if
those indirect costs (plus the insignificant direct
costs) of this option were to exceed the total direct
and indirect costs associated with either of the
other two options, then the fund could choose to
use one of those other, lower-cost options.
51 See Adopting Release, supra note 2, at n.81.
52 Slip Opinion, supra note 1, at 16–17.
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Court directed. This estimate also
includes possible increased
compensation to independent chairs to
reflect their additional responsibilities.
In addition to the monetary costs we
discuss below, some have raised, as a
possible non-monetary cost, the loss of
experience on the board if the interested
chairman were to resign from the board.
The interested chairman, however,
typically is one of the most senior
officers of the fund’s investment
adviser, which has a direct interest in
the operations of the fund. Therefore,
we anticipate that the interested
chairman is unlikely to resign from the
fund’s board, and will likely continue to
participate actively in board meetings
even though he no longer functions as
the chairman.53
A. Additional Staff
Several commenters suggested that an
independent chairman might decide to
hire staff to help fulfill his or her
responsibilities.54 Although we cannot
determine how many independent
chairmen would require the hiring of
additional staff to support them,55 we
have estimated the costs that fund
boards may incur as a result of hiring
additional staff.56
In our judgment, in most cases,
independent chairmen will be expected
53 Even in the unlikely case that the chairman
resigns from the board, we believe that the
resignation would have minimal costs because, as
discussed above and in the Adopting Release,
nothing in the Exemptive Rule amendments would
prohibit the former chairman from participating in
board meetings if the directors decide to include
him or her in those meetings. See supra note 49 and
accompanying text.
54 See, e.g., Comment Letter of Disinterested
Trustees of EQ Advisors Trust, File No. S7–03–04
(Mar. 4, 2004) (‘‘[A] fund group would need to
compensate the [independent] chair commensurate
with his or her additional responsibility and time
commitment and would need to hire additional
support for that individual.’’); Comment Letter of
New Alternatives Fund, Inc., File No. S7–03–04
(Feb. 9, 2004) (estimating a $25,000 cost of ‘‘aids
to directors’’); Comment Letter of Sullivan &
Cromwell LLP, File No. S7–03–04 (Mar. 9, 2004)
(‘‘[W]e believe that mandating an independent
chairman will effectively mandate the retention of
an independent staff and/or enhanced participation
by independent counsel in fund complexes both
large and small.’’). The [chief compliance officer]
and independent counsel were viewed as the
logical persons to interface regularly with the Chair
and their involvement may alleviate the need for
permanent staff to the board or Chair. The
management company typically provides the bulk
of the secretarial and clerical support for most
boards.’’). Despite the lack of consensus on whether
an independent chairman is likely to hire any
additional staff, the estimate discussed in this
section—to avoid any underestimate of costs—
assumes the hiring of two additional staff members.
55 Adopting Release, supra note 2, at n.81.
56 These costs are for additional staff. An
independent chair, like a management affiliated
chair, will continue to have available the services
of the existing staff of the fund management
company.
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to hire no more than two staff
employees, consisting of one full-time
senior business analyst and one fulltime executive assistant. We believe that
these costs will be borne primarily by
larger fund complexes, and that
independent chairmen at smaller
complexes will rarely choose to hire
additional staff. We have estimated the
costs of retaining these personnel based
on salary surveys conducted by the
Securities Industry Association (‘‘SIA’’),
a source on which we commonly rely in
our rulemakings.57 The SIA found the
average salary (including bonus) of a
senior business analyst to be
$136,671.58 Adjusting this salary
upwards by 50 percent to reflect
possible overhead costs and employee
benefits, this salary amounts to
$205,007. The SIA found the average
salary of an executive assistant
(including bonus) to be $73,088.59
Adjusting this salary upwards by 50
percent to reflect possible overhead
costs and employee benefits, this salary
amounts to $109,632. Thus, the hiring of
both a full-time senior business analyst
and a full-time executive assistant for an
independent chairman would total
approximately $314,639 for each board.
This cost can be expressed on a per fund
basis, which we calculate to be
$42,519.60
Some commenters suggested that
another cost of the amendments could
result from increased reliance by the
independent chairman on the services
of independent legal counsel.61 Based
57 See, e.g., Disclosure Regarding Approval of
Investment Advisory Contracts by Directors of
Investment Companies, Investment Company Act
Release No. 26486 (June 23, 2004) [69 FR 39798
(June 30, 2004)] at n.55.
58 See Securities Industry Association, REPORT
ON MANAGEMENT & PROFESSIONAL EARNINGS
IN THE SECURITIES INDUSTRY (2004). This
estimate is for a New York salary. The SIA also
estimates non-New York salaries, which are lower.
The estimates in this section use the higher figure.
59 See Securities Industry Association, REPORT
ON OFFICE SALARIES IN THE SECURITIES
INDUSTRY (2004).
60 This estimate is based on the following
calculation: ($314,639 ÷ 7.4 funds per board =
$42,519 per fund). We estimate that there are, on
average, 7.4 funds per board. There were 8126
funds in 2003. See Investment Company Institute,
2004 MUTUAL FUND FACT BOOK (May 2004). We
estimate that there are approximately two boards of
directors per fund complex. We also estimate that
in 2003 there were 550 fund complexes, yielding a
total of 1100 fund boards. Therefore, there are
approximately 7.4 funds per board (8126 funds ÷
1100 boards).
This estimate exceeds an estimate provided by a
commenter. See Comment Letter of New
Alternatives Fund, Inc., File No. S7–03–04 (Feb. 9,
2004) (estimating a $25,000 cost of ‘‘aids to
directors’’).
61 See, e.g., Comment Letter of Sullivan &
Cromwell, LLP, File No. S7–03–04 (Mar. 9, 2004)
(‘‘[W]e believe that mandating an independent
chairman will effectively mandate the retention of
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upon our experience, we estimate that,
on average, the independent chairman
will use independent legal counsel a
total of 50 hours a year more under the
amendments. We have estimated that
the average hourly rate for an
independent counsel is $300,62 which
yields a total cost of $15,000 annually,
per board. This amounts to $2027 per
fund.63
B. Increased Compensation for an
Independent Chairman
We estimate that compensation for an
independent chairman may be from 25
to 50 percent higher than the
compensation of other directors.64 In
order to calculate maximum likely costs
and avoid understating those costs, the
estimate in this section will use the
assumption of the higher end of the
range, i.e., a 50 percent premium, and
takes into account the 20 percent
increase reflecting possible increased
compensation costs.65 Therefore, based
on the estimates discussed above
regarding compensation for fund
independent directors,66 we estimate
that the additional ongoing
compensation cost, and other cost
increases, of appointing an independent
director as chairman could range from
$1147 to $9000 each year, per fund.67
3. Promotion of Efficiency, Competition
and Capital Formation
As noted by the Court, we must
consider the impact of the costs of
compliance with the two conditions,
both quantitative and qualitative, on
funds’ efficiency, competition and
capital formation. We find that the costs
of the 75 percent condition and of the
independent chairman condition are
extremely small relative to the fund
an independent staff and/or enhanced participation
by independent counsel in fund complexes both
large and small.’’).
62 See supra note 36.
63 This estimate is based on the following
calculation: ($15,000 ÷ 7.4 funds per board = $2027
per fund).
64 See Beagan Wilcox, ‘‘Wanted: Independent
Chairmen,’’ Board IQ, July 6, 2004 (citing estimate
of Meyrick Payne, senior partner, Management
Practice Inc.).
65 See supra text accompanying note 44.
66 See supra Section III.A.1.
67 These estimates are based on the following
calculations: (($4779 + $956) × 1.2 ÷ 3 × .5 = $1147);
(($37,500 + $7500) × 1.2 ÷ 3 x .5 = $9000). Funds
that already have 75% independent directors would
only incur costs for the additional pay when one
of these directors is appointed chairman. The costs
for funds that must appoint or elect new
independent directors is discussed in the previous
section. We expect that almost all funds that do not
have an independent chairman would select one of
the current independent directors to be the
chairman. If a fund chooses to recruit an
independent chairman, however, the fund would
incur recruiting costs in the first year equal to the
independent chairman’s first year salary.
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assets for which fund boards are
responsible, and are also small relative
to the expected benefits of the two
conditions. We expect that the minimal
added expense of compliance with these
conditions will have little, if any,
adverse effect on efficiency, competition
and capital formation. Indeed, we
anticipate that compliance with the two
conditions by funds that rely upon the
Exemptive Rules will help increase
investor confidence, which may lead to
increased efficiency and
competitiveness of the U.S. capital
markets. We also anticipate that this
increased market efficiency and investor
confidence may encourage more
efficient capital formation.
With respect to the 75 percent
condition, even for funds that elect to
add independent directors and are
required to solicit proxies, the costs are
minor compared to the amount of assets
under management. For funds that
choose to comply with the 75 percent
condition simply by decreasing the size
of the board, the costs are insignificant.
For funds that appoint three new
independent directors, using the data
from the 2004 survey and adding a 20
percent cushion as discussed above, the
ongoing annual costs range from
$64,800 per fund, for boards that
oversee only one fund, down to $7037
per fund, for boards that oversee a large
number of funds.68 Start-up costs in the
first year are somewhat more per fund:
from $100,800 per fund for boards that
oversee only one fund, to $11,624 per
fund for boards that oversee a large
number of funds.69 For funds that
cannot appoint the new directors and
must solicit proxies, the first year costs
per fund increase to $190,800 for boards
that oversee only one fund, and to
$101,624 for boards that oversee a large
number of funds.70 Using any of the
options, the costs per fund will be no
more than a very small fraction of the
fund assets for which the fund boards
are responsible.71
The costs of the independent
chairman condition are likewise small.
Even if the independent chairman hires
two full-time staff (at New York
salaries), and uses 50 hours of
supra note 46.
supra note 44.
70 See supra note 45.
71 We estimate that average fund assets in 2003
were $912 million based on a total of assets in 2003
of $7.414 trillion and a total of 8,126 mutual funds
(excluding funds that invest in other mutual funds).
See Investment Company Institute, 2004 MUTUAL
FUND FACT BOOK, at 113. Fund expenses are
typically measured as a percentage of assets under
management and are required to be disclosed to
investors in this manner. See Item 3 of Form N–1A.
We believe that comparison to net assets is the most
helpful for investors.
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68 See
69 See
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39395
additional independent legal counsel,
the total is only $329,639,72 which
would be divided among the number of
funds overseen by the independent
chairman. And the additional per fund
compensation received by the
independent chairman could range from
$9000 for an independent chairman
who oversees a single fund, down to
$1147 for an independent chairman
who oversees a large number of funds.
Even using the highest additional
compensation figure, the average fund
will incur a total cost for staff, legal
counsel and additional compensation of
only $47,220.73
Whether the two conditions are
viewed separately or together, even at
the high end of the ranges, the costs of
compliance are minimal.74 We also note
that the ranges of costs considered
above represent the high range of
potential cost of compliance for any
individual fund. The average cost per
fund to the industry as a whole will
likely be much lower.75 At the time we
adopted the rule amendments, 60
percent of funds already complied with
the 75 percent condition and will incur
no additional cost as a result of the
implementation of that condition.
Moreover, we expect few boards to
appoint or elect as many as three new
independent directors. Most are likely
to decrease the size of their board or add
one or two new directors. Our highest
cost estimates are for boards that
oversee only a single fund, which is an
atypical situation. We think it unlikely
that such a board would choose the
72 Two full-time staff ($314,639) plus 50 hours of
independent counsel ($15,000) equals $329,639.
73 Two full-time staff per fund ($42,519, see supra
text accompanying note 60) plus 50 hours of legal
counsel per fund ($2027, see supra text
accompanying note 63) plus $2674 (increased
compensation and recruiting costs for an
independent chairman) equals $47,220. The
increased compensation and recruiting costs for the
independent chairman was calculated based on a
board that oversees 7.4 funds. See supra 60. The
estimate of $2674 is based on the following
calculation: ((($27,480 median compensation for a
director that oversees 7 to 19 funds ÷ 7.4 funds) +
$743 recruiting costs) × 1.2 20% cost increase × .5
= $2674). The median salary for a board overseeing
7 to 19 funds was based on data provided in the
April 2004 MPI Bulletin, supra note 24.
74 These costs represent our best estimates of the
ranges. We recognize that there may be ancillary
costs, but we expect them to be minor and such
costs should be covered by the generous cushion we
have built into our estimates and by our use of the
high end of the cost ranges. Moreover, in light of
the benefits, we believe that even if the costs were
several times higher, they would continue to be
minimal and the rule amendments would still be
justified.
75 While the high-end costs may be applicable to
a given fund, the high-end costs clearly will not be
applicable to all funds or even most funds. It would
be incorrect, and indeed misleading, to take the
highest possible cost for a single fund and
extrapolate for the entire industry.
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more costly options of adding as many
as three new directors and hiring two
full-time staff to assist the independent
chairman.76
Moreover, these costs are slight in
relation to the very important benefits of
the two conditions, as more fully
discussed in the Adopting Release. The
75 percent condition is intended to
promote strong fund boards that
effectively perform their oversight role.
Enhanced oversight by a strong,
effective and independent fund board
will serve to protect funds and their
shareholders from abuses that can occur
when funds engage in the conflict-ofinterest transactions permitted under
the Exemptive Rules. This will increase
investor confidence in fund
management and promote investment in
funds. While these benefits are not
easily quantifiable in terms of dollars,
we believe they are substantial,
particularly in comparison to the
estimated cost of compliance. The
independent chairman condition will
provide similar benefits. The chairman
of a fund board can have a substantial
influence on the fund board agenda and
on the fund boardroom’s culture. An
independent chairman 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.
Moreover, an independent board led by
an independent chairman is more likely
to vigorously represent investor
interests when negotiating with the fund
adviser on matters such as fees and
expenses. We find that these cumulative
benefits fully justify the costs associated
with the rule amendments. Further, it is
our judgment that, in the future, each of
the proposed amendments is likely,
when taken together with other
Commission reforms, to have a
significant potential prophylactic
benefit in preventing harm from
conflict-of-interest transactions—itself a
benefit sufficient to justify these costs.
Consistent with our view expressed in
the Adopting Release, we do not expect
76 Because we find the adoption of the two
conditions to be appropriate even looking at the
high end of the range of costs, we would reach the
decision not to modify the rule amendments even
apart from our discussion of the rest of the range
of costs. However, we consider that range pertinent
and helpful in reinforcing our determination. Our
use of the high end of the range also offsets any
potential benefit from seeking information as to
costs incurred by funds that have come into early
compliance with the two conditions since the date
of our original adopting release (which funds are
likely to constitute an evolving subset that may, in
any event, not be representative of funds more
generally). As we have previously noted, engaging
in further notice and comment procedures to obtain
additional information would create a risk of
significant harm to investors.
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the amendments to the Exemptive Rules
to have a significant adverse effect on
efficiency, competition or capital
formation because the costs associated
with the amendments are minimal and
many funds have already adopted the
required practices.77 To the extent that
these amendments do affect competition
or capital formation, we said we
believed, and we continue to believe,
that the effect would be positive. Among
other things, we believe the 75 percent
and independent chairman conditions
would enhance the quality and
accountability of the fund governance
process. The estimates discussed in this
release of the costs associated with
compliance with the 75 percent
condition and the independent
chairman condition, and our further
consideration of the effect of those costs
on efficiency, competition and capital
formation, do not alter this conclusion.
We believe that a more robust system of
checks and balances on fund boards
should raise investors’ expectations
regarding the governance of these
funds.78 By promoting investor
confidence in the fairness and integrity
of the individuals that monitor
investment companies, we promote
investor confidence in the fairness and
integrity of our markets. Investors will
likely be more willing to effect
transactions in those markets, which in
turn will help to increase liquidity and
to foster the capital formation process.
Increased investor confidence in the
integrity of mutual funds also will lead
to increased efficiency and
competitiveness of the U.S. capital
markets.
B. Consideration of the Disclosure
Alternative
The Court of Appeals also stated that
the Commission did not give adequate
consideration to an alternative to the
independent chairman condition,
discussed by the two dissenting
Commissioners, that ‘‘each fund be
required prominently to disclose
77 See Adopting Release, supra note 2, at Section
VIII. The costs for any fund are sufficiently small
that we think any adverse effect on competition will
continue to be minimal and will be justified by the
benefits of the rule, especially given our judgment
that small funds will choose options for compliance
with the conditions at cost levels that do not
approach the upper end of the range.
78 See, e.g., Comment Letter of Morningstar, Inc.,
File No. S7–03–04 (Mar. 10, 2004) (‘‘Overall, we
support the proposal, which should be beneficial in
restoring the system of checks and balances that is
essential to ensuring that the interests of fund
shareholders are represented.’’); Comment Letter of
Joseph J. Kearns, File No. S7–03–04 (June 3, 2004)
(‘‘Having an independent chairman is in my
opinion the most important governance regulation
needed. * * * The shareholders need to see that
boards are truly independent including their
leadership.’’).
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Frm 00008
Fmt 4701
Sfmt 4700
whether it has an inside or an
independent chairman and thereby
allow investors to make an informed
choice.’’79 As discussed below, we do
not believe this proposal—to provide
information to enable an informed
investment decision—would adequately
protect fund investors from the potential
abuses inherent in the conflict-ofinterest transactions permitted under
the Exemptive Rules. We reach this
conclusion in light of the nature of
investment companies and the purposes
of the statutory prohibitions to which
the Exemptive Rules apply.
As we explained in the release
proposing the 2001 amendments to the
Exemptive Rules, funds are unique in
that they are organized and operated by
people whose primary loyalty and
pecuniary interest lie outside the
enterprise.80 This ‘‘external
management’’ structure presents
inherent conflicts of interest and
potential for abuses. The investment
adviser firms that manage the funds
have interests in their own profits that
may conflict with the interests of the
funds they manage. And in many cases,
as we noted in the Adopting Release,
fund boards continue to be dominated
by their management companies.81
It was to address these conflicts of
interest that Congress in 1940 enacted
the Investment Company Act, including
the statutory prohibitions to which the
Exemptive Rules apply.82 Congress
found that the disclosure regimes of the
Securities Act of 1933 and the Securities
Exchange Act of 1934 were inadequate
79 Slip Opinion, supra note 1, at 17. In their
dissent to the adoption of the rule amendments,
Commissioners Glassman and Atkins said: ‘‘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.’’ Adopting Release, supra note 2, Dissent of
Commissioners Cynthia A. Glassman and Paul S.
Atkins, at text following n.46.
80 See Role of Independent Directors of
Investment Companies, Investment Company Act
Release No. 24082 (Oct. 14, 1999) [64 FR 59826
(Nov. 3, 1999)], at n.9 and accompanying text.
81 Adopting Release, supra note 2, at text
preceding n.8.
82 See, e.g., S. Rep. No. 1775, 76th Cong., 3d Sess.
7 (1940):
The representatives of the investment trust
industry were of the unanimous opinion that ‘‘selfdealing’’—that is, transactions between officers,
directors, and similar persons and the investment
companies with which they are associated—
presented opportunities for gross abuse by
unscrupulous persons, through unloading of
securities upon the companies, unfair purchases
from the companies, the obtaining of unsecured or
inadequately secured loans from the companies,
etc. The industry recognized that, even for the most
conscientious managements, transactions between
these affiliated persons and the investment
companies present many difficulties.
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to cope with the type of conflicts and
abuses that pervaded the investment
company industry.83 The Investment
Company Act, with its prohibitions
against transactions involving conflicts
of interest and its detailed prescriptions
for the organization and governance of
investment companies—particularly the
setting of standards for independent
directors, and their role as ‘‘watchdogs’’
for the interests of fund shareholders—
played a crucial role in restoring
confidence in investment companies as
a regulated medium for investor savings.
In the case of ordinary business
corporations, the Federal securities laws
protect investors by providing
disclosure to enable them to make an
informed investment decision.84 Even
with respect to conflicts of interest on
the part of managers of investment
companies, disclosure in some cases can
provide important protections. In the
context of the subject of this
rulemaking, for example, disclosure
may enable fund investors to decide
whether to invest in a fund that does not
have an independent chair. But the
utility of such disclosure is limited.
Disclosure concerning conflicts of
interest on the part of fund managers
and the potential for self-dealing by
them does not prevent the managers
from putting their interests ahead of
investors’ interests. Disclosure does not
prevent them from engaging in selfdealing. While this is also true in the
case of managers of ordinary companies,
investment companies are different in
this regard because of the structure and
purposes of the Investment Company
Act. That Act prohibits certain
transactions that involve conflicts of
interest and the resulting potential for
self-dealing. Indeed, protection against
harm from self-dealing is one of the
express purposes of the Investment
Company Act.85 We believe the
objectives of these conflict-of-interest
prohibitions of the Act will best be
served by strengthening—through
enhanced independent oversight—
investor confidence that those charged
with managing their fund will act in the
83 See, e.g., H.R. Rep. No. 2639, 76th Cong., 3d
Sess. 10 (1940):
The Securities Act of 1933 and the Securities
Exchange Act of 1934 have not acted as deterrents
to the continuous occurrence of abuses in the
organization and operation of investment
companies. Generally these acts provide only for
publicity. The record is clear that publicity alone
is insufficient to eliminate malpractices in
investment companies.
84 Even in the context of ordinary business
corporations, the federal securities laws do not rely
exclusively on disclosure. See, e.g., section 13(k) of
the Securities Exchange Act of 1934, 15 U.S.C.
78m(k) (prohibition on personal loans to
executives).
85 See Section 1 of the Act, 15 U.S.C. 80a-1.
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investors’ interests. Under these
circumstances, we do not believe that
disclosure alone is sufficient to
adequately protect a fund investor
against the serious risk that the
managers of his or her investment will
engage in self-dealing.86
Moreover, even if we assume that
meaningful disclosure would be an
adequate alternative to a requirement of
an independent chair, there are
obstacles to making disclosure that
would be meaningful. We doubt the
sufficiency of merely disclosing that a
fund does not have such a chair.87 For
prospectus disclosure to be meaningful,
investors considering a fund would
have to be informed of the conflicts of
interest faced by fund advisers, the
complex role of the fund board in
managing those conflicts, and the
potential consequences to investors of
the failure of fund boards to protect
against conflicts. It would be difficult to
provide meaningful disclosure of these
matters.
In addition, we did not adopt the
independent chairman provision in
isolation. We adopted it as part of a
larger package of regulatory reforms that
should lead to enhanced compliance by
funds that have independent chairs.88
The independent chairman will be in a
position to receive reports from the
fund’s compliance personnel. Under
rules we adopted in December 2003,
each fund is required to have a chief
compliance officer who is responsible
for, among other things, keeping the
fund’s board of directors apprised of
significant compliance events at the
fund or its service providers and for
advising the board of needed changes in
the fund’s compliance program.89
We also observed that the chairman
can play an important role ‘‘in
establishing a boardroom culture that
can foster the type of meaningful
dialogue between fund management and
86 The disclosure alternative would benefit
prospective or future investors to a greater degree
than existing investors in a fund. Existing investors,
once they receive disclosure of the independence of
the board’s chairman, may not be able to redeem
without incurring costs, due to deferred sales loads,
redemption fees, taxes, or other transaction costs.
See Payment of Asset-Based Sales Loads by
Registered Open-End Management Investment
Companies, Investment Company Act Release No.
16431 (June 13, 1988) [53 FR 23258 (June 21, 1988)]
at text following n.188 (noting the restrictions on
the ability of existing investors to ‘‘vote with their
feet’’).
87 Indeed, most funds already disclose in their
public filings whether the chairman of the board is
independent.
88 See Adopting Release, supra note 2, at text
accompanying nn. 5–6.
89 Compliance Programs of Investment
Companies and Investment Advisers, Investment
Company Act Release No. 26299 (Dec. 17, 2003) [68
FR 74714 (Dec. 24, 2003)].
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39397
independent directors that is critical for
healthy fund governance.’’ 90
Meaningful dialogue is particularly
important where the board is evaluating
the types of transactions permitted by
the Exemptive Rules. A board can most
effectively manage the conflicts of
interest inherent in these transactions
where the board culture encourages
rather than stifles open and frank
discussion of what is in the best interest
of the fund. This is especially true in
connection with the conflicts of interest
presented by these transactions because
the best interest of the fund frequently
is different from the best interest of the
fund’s management company. Similarly,
we stated that the chairman of a fund
board ‘‘is in a unique position to set the
tone of meetings and to encourage open
dialogue and healthy skepticism.’’ 91 An
independent chairman is better
equipped to serve in this role. An
independent chairman also can play an
important role in serving as a
counterbalance to the fund’s
management company by providing
board leadership that focuses on the
long-term interests of investors.
None of these benefits can be
achieved merely by disclosure. We
continue to find that it is necessary and
appropriate in the public interest and
consistent with the protection of
investors to condition a fund’s reliance
upon any of the Exemptive Rules upon
its having an independent chairman.
IV. Response to Comments of Dissenting
Commissioners at Open Meeting
At the Commission’s open meeting in
this matter, the dissenting
Commissioners 92 raised various
objections to our response to the Court
of Appeals. The dissenters, echoing
requests made by others, claim (i) that
we are acting too quickly, which
prevents further notice and comment
procedures that are either required or
desirable, and which prevents sufficient
consideration by the staff and
Commission, (ii) that our action is
inconsistent with certain aspects of the
Court’s opinion, (iii) that we did not
seek comments on the costs associated
with the independent chair condition at
the time of the initial rulemaking, and
(iv) that acting so quickly is
90 See Adopting Release, supra note note 2, at text
preceding n.47.
91 Id. at text following n. 50.
92 Commissioners Cynthia A. Glassman and Paul
S. Atkins (‘‘dissenters’’) voted against this Response
to Remand by Court of Appeals. Although
Commissioner Glassman provided a written copy of
her oral remarks made at the meeting, the
dissenting Commissioners did not otherwise
provide us with copies of their written dissents
prior to the completion of this Release.
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unprecedented and unjustified. We
disagree.
We have largely addressed these
concerns, which are inter-related in
many respects, previously in this
Release. We have discussed the reasons
that further notice and comment
procedures are not required, finding that
the existing record, together with other
information on which the Commission
may rely, is a sufficient basis for our
decision on remand.93 We also have
explained why, although they are not
required, we should not under the
circumstances engage in further notice
and comment procedures.94
We have furthermore explained the
need to act promptly in this matter,
noting, among other things, the
importance of avoiding a postponement
of the compliance date and the
attendant potential harm to investors
and the market that would result.95 We
find that any further delay or ambiguity
surrounding implementation of the
rules would disadvantage not only
investors but also fund boards and
management companies, most of which
have already begun the process of
coming into compliance with the rules.
By acting swiftly and deliberately to
respond to the Court’s remand order, the
Commission will reduce uncertainty,
facilitate better decision-making by
funds, and ultimately serve the interests
of fund shareholders. We also note that
the issues remanded to us by the Court
are discrete and clearly defined; 96
93 See supra Section II. As noted in our Adopting
Release, we received nearly 200 comments from
fund investors, management companies,
independent directors to mutual funds, as well as
members of Congress; and we also received several
comments from organizations that had a more
general interest in corporate governance issues. See
Adopting Release, supra note 2, at Section I.
Commissioner Glassman disputed that we sought
comments in the Proposing Release on the costs
associated with the independent chairman’s hiring
of additional staff. In support of this, she cited
language in the Proposing Release which, she
argues, requested comments on certain other costs
but ‘‘expressly declined’’ to request comments on
the cost of the independent chairman’s hiring of
additional staff. This is incorrect. In fact, the
Proposing Release expressly sought comments on
‘‘the costs’’ of the condition requiring ‘‘[a]n
independent director to be chairman of the board.’’
See Proposing Release, supra note 11, at Section
V.B. In addition, the Proposing Release included a
general request for comments on the potential costs
and benefits of the rule. See id., at Section V.C.
94 See supra Section II & note 76. Commissioner
Glassman argues that we are using estimates rather
than ‘‘actual data’’ when ‘‘actual costs’’ are
available, now that funds have started to come into
compliance with the rule amendments. As
discussed above, however, the estimates are based
on actual data previously available to us; and, for
reasons stated above, we have determined that it is
unnecessary to supplement that data with
information about funds that have come into early
compliance. See supra note 76.
95 See supra Section II.
96 See Slip Opinion, supra note 1, at 2, 15–17.
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indeed, the Court observed that part of
our task on remand could be
accomplished ‘‘readily.’’ 97
With respect to suggestions by the
dissenters that our response to the
disclosure alternative is inconsistent
with the Court’s opinion, we note that
our discussion sets out the reasons why
the Commission does not believe that
the disclosure alternative is superior for
achieving the objectives of the Act,
including those of the specific conflictof-interest provisions that are addressed
by the Exemptive Rules.98
Finally, we note that it is in the best
tradition of this institution, and not at
all unusual, for the Commission to act
swiftly on important initiatives in
response to market developments and
other factors. The Commission has done
so on many occasions previously. In this
matter, the staff and the Commission
have a strong foundation of experience
with the fund governance rules, and that
experience has enabled us to address
the issues raised by the Court within a
relatively short period of time, with the
assistance and extraordinary efforts of
our staff.
V. Conclusion
We believe that this release fully
addresses the two issues remanded to us
for our further consideration and
explication. The Commission
commends the efforts of the
Commission staff in this matter. The
staff worked with great diligence, care
and tirelessness, as well as with its
usual even-handedness in the treatment
of all Commissioners. We further
commend the staff for maintaining this
high degree of professionalism in the
face of a sharply divided Commission,
and against the backdrop of a campaign
of unwarranted public attacks on the
Commission and its processes
apparently orchestrated by some outside
the Commission.
Upon our further consideration of the
costs and of the disclosure alternative,
we have concluded that the benefits of
the 75 percent independent director
condition and the independent
chairman condition far outweigh their
costs, and that the disclosure alternative
does not afford adequate protection to
fund investors. Accordingly, we have
determined not to modify the
amendments.
*
*
*
*
*
By the Commission.
at 16.
supra Section III.B. (Consideration of the
Disclosure Alternative).
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98 See
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Dated: June 30, 2005.
Margaret H. McFarland,
Deputy Secretary.
Concurring Views of Chairman
Donaldson at Open Commission
Meeting Commission Response To
Remand by Court of Appeals
The last item on our agenda is a
recommendation from the Division of
Investment Management relating to
rules we adopted last year to enhance
the governance practices of mutual
funds. As a condition to a mutual fund
engaging in certain transactions
involving conflicts of interest with the
fund’s management company, the rules
require that the fund have a board with
at least 75 percent independent
directors and an independent chairman.
The Commission voted to approve
these fund governance rules in June
2004, and we are acting today as a result
of a recent decision by the District of
Columbia Circuit Court of Appeals in a
case brought by the Chamber of
Commerce. In that case, the Court
agreed with the Commission on two
central points: first, that the
Commission had the statutory authority
under the Investment Company Act to
adopt the fund governance rules; and
second, that the Commission’s
underlying policy rationale for adopting
the rules was reasonable.
However, the Court remanded two
issues for our consideration. The Court
instructed the Commission to further
consider certain potential costs of the
new rules, and to consider a potential
alternative to the independent chair
rule. Today’s recommendation
addresses the Court’s concerns, which
we take quite seriously.
Before turning to the specific issues
raised by the Court, I would like to
briefly put this rulemaking in
perspective and highlight some of the
very important benefits that I believe it
will bring to investors and to the mutual
fund industry.
When Congress enacted the
Investment Company Act in 1940, it
recognized that conflicts of interest in
the mutual fund industry pose serious
risks to fund shareholders. Funds are
organized and operated by people
whose primary economic interests lie
outside the enterprise, and, without
appropriate checks and balances, this
structure can readily lead to abuse. To
address the conflicts, Congress
established minimum governance
requirements under the Act, based on its
determination that a fund’s board of
directors, particularly its independent
directors, should serve as watchdogs to
protect the interests of investors.
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Congress also prohibited funds from
engaging in certain types of affiliate
transactions and other transactions that
are most susceptible to abuse, while at
the same time granting the Commission
broad authority to provide exemptions
when in the public interest. Since 1940,
the Commission has adopted a variety of
exemptive rules that permit otherwise
prohibited transactions, but only under
certain carefully tailored conditions,
which include active oversight by
independent directors.
Beginning in 2003, a series of
scandals were uncovered in the mutual
fund industry involving truly egregious,
illegal and unethical behavior on the
part of fund advisers. Advisers in a host
of different fund complexes knowingly
endorsed, among other abuses, late
trading, market timing (including some
advisers timing their own funds),
directed brokerage, and selective
disclosure to favored investors. The
scandals resulted in enormous losses for
investors, and revealed systemic
breakdowns in compliance systems,
weaknesses in fund governance
structures and a significant betrayal of
investors’ trust.
The Commission responded to the
scandals in a swift and comprehensive
manner. We have brought numerous
enforcement cases and obtained over
$2.2 billion in disgorgement and
penalties, which can be used to
compensate harmed investors. In
addition, in the last year and a half, the
Commission has adopted a number of
rules designed to ensure better
compliance by funds and advisers with
the Federal securities laws, promote the
accountability of fund officers and
directors, and enhance disclosure to
investors.
The fund governance rules are a
critical component of the Commission’s
reform efforts. By strengthening the role
of the independent directors, the rules
enhance the ability of fund boards to
provide badly needed oversight of the
activities of their advisers and monitor
conflicts of interest. The independent
chair condition allows individuals who
are truly free from conflict to exercise
leadership in the boardroom. This point
was underscored in a comment letter
submitted by all seven of the living
former Chairmen of the Commission,
who wrote: ‘‘An independent mutual
fund board chairman would provide
necessary support and direction for
independent fund directors in fulfilling
their duties by setting the board’s
agenda, controlling the conduct of
meetings, and enhancing meaningful
dialogue with the adviser.’’
The Commission recognizes that there
are fund chairmen who strive to
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represent the interests of fund investors
in the boardroom while also serving as
executives of the fund’s adviser. But
they undeniably face a central conflict
of interest. When the CEO of a mutual
fund’s adviser is simultaneously serving
as the chairman of the mutual fund
itself, this person is in the untenable
position of having to serve two masters.
On the one hand, he or she owes a duty
of loyalty and care to the mutual fund;
on the other hand, the person owes a
separate duty to the shareholders of the
fund’s investment adviser. It is easy to
see that these two duties are often in
conflict, particularly when it comes to
setting the level of fees the fund will
pay the adviser.
The independent chair condition is
the capstone of our series of mutual
fund governance reforms that will help
foster a culture in fund boardrooms
based on transparency, arm’s length
dealing, and, above all, protection of the
interests of fund shareholders. The rules
will also, I believe, help to strengthen
the compliance function at mutual
funds by providing a truly independent
body to which the chief compliance
officer can report.
Before turning to today’s proposals, I
would like to underscore an important
point. The recent opinion of the Court
of Appeals upheld the validity of the
fundamental rationale underlying the
Commission’s fund governance rules.
The Court agreed with the Commission
that strengthening the role of
independent fund directors was a
reasonable response to the risks of
further abuse in the mutual fund
industry. Moreover, as I noted a moment
ago, the Court found that the governance
rules fall within the Commission’s
statutory authority under the Investment
Company Act and, specifically, that the
emphasis on independent directors is
consistent with the structure and
purpose of the Act.
The Court identified two specific
issues that required further
consideration by the Commission. First,
with respect to costs, the Court stated
that the Commission should give further
consideration to the potential costs of
the 75 percent independent director
condition and the independent chair
condition. Prior to adopting the fund
governance rules, the Commission
sought and received comment on the
costs associated with these conditions,
and we concluded that the costs were
minimal in relation to the benefits. As
instructed by the Court, today’s
proposal provides a detailed estimate of
these potential costs, based on a variety
of different possible approaches of
complying with the new rules, and the
Commission has carefully considered
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39399
the potential impact of these costs. I will
leave it to the staff to explain the
numbers in greater detail, but suffice it
to say that our analysis strongly
confirms the conclusion that the
potential costs to mutual funds of
appointing independent chairmen, and
ensuring that 75 percent of their
directors are independent, are minimal
when compared to the substantial
benefits that these governance rules can
bring in terms of reducing conflicts of
interest and protecting investors.
Second, with respect to alternatives,
the Court asked the Commission to give
further consideration to an alternative to
the independent chair condition that
would require funds simply to disclose
whether or not they have independent
chairmen. This is an issue on which we
received comment prior to adopting the
independent chair rule last year, and
today’s proposal explains our reasons
for rejecting the disclosure alterative.
While many of our other rules are based
on disclosure requirements, there are
important reasons for taking a stronger,
more substantive approach in the
context of mutual fund governance. As
I noted a few moments ago, the very
structure of the typical mutual fund
gives rise to serious conflicts of interest
between the adviser and the
shareholders, and this is the reason that
Congress established flat prohibitions
on certain types of fund transactions.
For the Commission to grant exemptions
from these prohibitions, we must see to
it that investors are given assurances
that their interests will be protected. As
adopted, the independent chair
condition will go a long way toward
providing those assurances. Relying
solely on disclosure, on the other hand,
would allow a flawed governance
structure to continue in many funds to
the detriment of fund shareholders.
Concern has been raised about the
timing of the Commission’s actions
today. The Commission’s actions today
are fully consistent with the opinion of
the Court of Appeals and with the other
legal requirements applicable to
Commission rulemaking. The issues
raised by the Court are clearly defined,
and the existing rulemaking record and
other publicly available materials have
permitted the Commission to address
them in the manner contemplated by
the Court without further notice and
comment. Indeed, by not vacating the
governance rules, but instead remanding
them to the Commission without
ordering any particular procedures, the
Court contemplated that any
deficiencies in the initial rulemaking
could be cured without unnecessarily
reversing course or restarting the
rulemaking process.
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Moreover, there are compelling policy
reasons for the Commission to act
expeditiously on these matters. As I
have stated, the governance rules are a
critical component of our reform efforts,
and any further delay or ambiguity
surrounding their implementation
would disadvantage not only investors
but fund boards and management
companies, most of which have already
begun the process of coming into
compliance with the rules. By acting
swiftly and deliberately to respond to
the Court’s concerns, the Commission
will facilitate better decision-making
and ultimately serve the interests of
fund shareholders.
I would also point out that it is in the
best tradition of this institution, and not
at all unusual, for the Commission to act
swiftly on important initiatives in
response to market developments and
other factors. In this case, the staff and
this Commission have a strong
foundation of experience with the fund
governance rules, and that experience
has enabled us to address the issues
raised by the Court within a relatively
short period of time, albeit with the
assistance of truly Herculean efforts on
the part of our staff.
There is another important reason for
us to act today. Our failure to act would,
I fear, throw the future of this
rulemaking into an uncertain limbo
until a new Chairman is confirmed and
the new Chairman is able to familiarize
himself with the rulemaking record and
the policy considerations weighing for
and against the decision that we made
last year. Today, however, we have
intact the full complement of
Commissioners who have spent the last
year-and-a-half thinking about the
issues raised in this rulemaking, and
with my imminent departure from the
Commission, today is the last
opportunity to bring the collective
judgment and learning of we five
Commissioners to bear on the important
questions presented to us by the Court.
Concurring Views of Commissioner
Harvey J. Goldschmid at Open
Commission Meeting Commission
Response To Remand by Court of
Appeals
As has just been demonstrated by
Commissioner Glassman, emotions have
run extremely high in this area. There
has been too much confusion and
hyperbole—‘‘hyperbole’’ is the most
gentle word that I can use. Among
others, I found her statement about the
staff’s cost analysis being ‘‘back of the
envelope’’ quite extraordinary. I
reviewed the cost analysis with great
care, and everyone knows how hard the
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staff has worked on it. It is a very
serious cost analysis.
Let me begin a more serious
discussion by making clear what the
D.C. Circuit Court did—and did not
do—on June 21st.
First, the Court expressly upheld our
statutory authority to require mutual
funds to have a board consisting of no
less that 75% independent directors and
an independent chair. In the face of
claims of ‘‘regulatory overreach,’’ the
Court held that the ‘‘Commission did
not exceed its statutory authority’’ in
adopting the two governance
conditions.
Second, there were challenges to the
wisdom and effectiveness of our mutual
fund governance provisions. I have
stated often that given the fundamental
need for directors to deal with the
inherent conflicts of investment
managers, a critical mix of at least 75%
of independent directors makes
compelling policy sense. The Supreme
Court has described mutual fund
independent directors as necessary
‘‘watchdogs’’ to police mutual fund
conflicts of interest. Similarly, an
independent chair helps to ensure
proper information flows, establish
sensible board priorities and agendas,
and encourage candid and thorough
discussions in the boardroom.
The D.C. Circuit Court recognized our
prudence in ‘‘strengthening the role of
independent directors in relation to
exemptive transactions as a
prophylactic measure * * * .’’ The
Court held that our policy rationales for
the two new governance provisions
were justified.
Third, the Court then remanded in the
two deficiency areas that have been
identified , and asked us to address
them.
An initial issue for us was whether it
was necessary to engage in additional
fact-gathering or further notice and
comment procedures. We concluded
that the information in the existing
record (which had involved an
extensive notice and comment process)
provided a more than sufficient basis to
address the deficiencies. The Circuit
Court could, of course, have required us
to do new fact-gathering, but did not do
so.
Given what we believe is the
adequacy of the information available in
the record, there would be large costs to
new fact-gathering. By acting promptly
we avoid the cost of new fact gathering,
avoid what could be a substantial period
of uncertainty for mutual fund
governance, and ensure that fund
shareholders will receive the critical
protections afforded by the new
governance rules without further delay.
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The mutual fund business is based on
investor trust, and, after the grievous
breaches of trust disclosed by the
mutual fund scandals, it is of great
importance to continue to bolster
investor confidence in the governance of
funds.
This Commission has spent nearly
two years considering mutual fund
disclosure, governance, and other rules.
As was true of our action today on
‘‘securities offering reform,’’ we have
labored too hard—and the governance
provisions are too important—for us not
to act in the public interest. As
Chairman Donaldson put it, ‘‘failure to
act would have a severe detrimental
effect’’ on investors. Of course, as we
have just done with respect to securities
offering reform, a future Commission
would be able to modify or reverse
anything we do today that the new
Commission concludes is
counterproductive.
Let me now address briefly the
crocodile tears being shed about the
need to not move forward out of respect
for the Court of Appeals. I believe that
the release we will approve today fully
responds to the Court’s concerns. I have
great respect for our panel of three
strong, highly intelligent and talented
judges. This matter will quickly be back
before those judges. If we are wrong
about being fully responsive, the Court
will certainly tell us so. But, if we are
right about being fully responsive, we
will have ensured an enormously better
day for investors in mutual funds. As
the Circuit Court recognized, our two
governance rules are designed to
strengthen the independence and
effectiveness of fund boards, and
thereby, protect shareholders from
serious conflicts of interest.
Obviously, for me, in an $8 trillion
industry, the benefits of the two new
governance provisions plainly and
overwhelmingly outweigh their costs.
A full discussion of the ‘‘disclosure
alternative’’ to the independent chair
provision is contained in our release.
For now, let me just emphasize again
that the interrelation between
investment advisers and mutual funds
presents complex and pervasive
conflict-of-interest issues.
The dynamics of a mutual fund
boardroom—including what may be the
dominance of the chair (who often
controls information flows, board
agendas, etc.)—is extremely difficult to
disclose in a meaningful way. It is
similarly difficult for the 90-plus
million shareholders of mutual funds to
digest and evaluate. But those of us who
have spent most of our professional
lives working on issues of corporate
governance—and have witnessed the
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failings of mutual fund governance
demonstrated by nearly two years of
enforcement actions—fear that
permitting investment managers to
continue to chair mutual fund boards
would significantly increase the danger
of future abuse.
I think the same reasoning convinced
Congress in 1940, in enacting the
Investment Company Act, to go well
beyond disclosure and provide both
Exemptive Rules (prohibitions against
transactions involving conflicts of
interest) and detailed prescriptions for
the organization and governance of
mutual funds. As we said in our July
2004 Adopting Release: ‘‘[the chair of a
fund board] is in a unique position to
set the tone of meetings and to
encourage open dialogue and healthy
skepticism.’’ An independent chair can
both help to counterbalance the fund’s
investment adviser and provide
leadership that makes paramount the
interests of fund investors. Put bluntly,
the disclosure alternative does not
afford adequate protection to fund
shareholders. In this area, it is simply an
unrealistic idea.
Finally, this is Chairman Donaldson’s
final public meeting. I must express my
deep sadness—both on a personal level
and for all decent participants in our
financial markets—at his leaving. Bill,
you have played a major role in
restoring investor faith in the integrity
and fairness of the nation’s financial
markets. You have also restored the
public’s faith in the SEC. Your
leadership, honesty, and courage will
long be celebrated, and you will be
greatly missed.
The Commission staff has done a
splendid job on this release. Mike
Eisenberg, Bob Plaze, Giovanni
Prezioso, Jonathan Sokobin, and all the
rest of you, thanks for your terrific
effort.
I have no questions.
Concurring Views of Commissioner
Roel C. Campos at Open Commission
Meeting Commission Response To
Remand by Court of Appeals
Thank you Chairman Donaldson. I
have a short statement to make about
this action regarding our Agency’s
mutual fund governance rulemaking
and the Response to the Remand by the
Court.
I. American Mutual Fund Investors
Have Been Under Attack
Beginning about two years ago the
American public and this Agency
became suddenly aware that American
mutual fund investors were under
attack. In quick order, investigations by
this Agency and other State Attorney
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Generals revealed that dozens of well
known mutual fund families had turned
large profits at the expense of mutual
fund investors. Looking only at the top
nine fund families, billions of dollars
were literally stolen from mutual fund
investors by executives who placed
their personal gain above the interests of
their investors whom they were sworn
to protect. It became clear that many
fund executives participated in
sweetheart schemes in which privileged
third parties such as hedge funds were
allowed to market time mutual funds
and to engage in late trading, siphoning
off billions of dollars of fund value at
the expense of unknowing and
unsuspecting mutual fund investors.
Indeed the scandal and harm was so
egregious that Republican Congressman
Mike Oxley, who of course authored
with Senator Paul Sarbanes the famed
Sarbanes-Oxley Act, decided to study
the situation. Long a champion of
protecting investors, Congressman
Oxley did his homework and wrote
several strong letters of support for the
SEC’s subsequent independent
Chairman rulemaking that is the subject
of the Court’s Remand. In his letter to
the Commission dated May 20, 2004,
Congressman Oxley noted that he had
been closely following the debate
regarding the SEC’s proposal to require
independent fund Board Chairman.
After reviewing publicly available
information, the Congressman stated in
his letter that ‘‘The statistics I
uncovered are startling. Eighty-four
percent of the mutual fund families
implicated in the market timing and late
trading scandals (sixteen of the nineteen
mutual funds) have had managementaffiliated chairmen [non-independent]
at some point during the alleged or
admitted violations.’’ He noted the
SEC’s actions against Invesco Funds,
Franklin Templeton Funds, Janus,
Putnam, Strong Funds, and MFS Funds
in particular, which collectively settled
for a total of over $700 million in
disgorgement and penalties. Urging the
Commission to adopt the proposed rule
without amendment, Congressman
Oxley went on to say, ‘‘I believe the
Commission’s independent chairman
proposal would eradicate the selfdealing by interested, managementaffiliated chairmen and its harmful
effect on mutual fund shareholders.’’
Unfortunately, threats to mutual fund
investors continue to be uncovered by
our Agency. On May 31, 2005, for
example, the Commission announced a
settlement with Citigroup Global
Markets, Inc and Smith Barney Fund
Management. The Commission’s Order
noted that the investment adviser
placed its interest in making a profit
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ahead of the interests of the mutual
funds it had a duty to serve. In this case
the adviser recommended that the
mutual funds contract with an affiliate
of the adviser to serve as transfer agent
without fully disclosing to the mutual
funds’ boards that most of the actual
work was to be done under a
subcontract arrangement that had been
negotiated with the mutual funds’
existing third-party transfer agent at
steeply discounted rates. Rather than
passing the substantial fee discount on
to the mutual funds, the adviser,
through the newly created affiliated
transfer agent took most of the benefit of
the discount for themselves, reaping
nearly $100 million in profit at the
funds’ expense over a five year period.
The funds did not have an independent
Chairman. Citigroup and Smith Barney
paid over $200 million in disgorgement
and penalties.
II. The Agency’s Objective Has Been
Investor Protection and To Restore
Confidence
In response to this explosion of
mutual fund fraud and theft by adviser
executives, the Agency moved promptly
to protect investors. It designed a
combination of new governance and
compliance rules. One of these rules
mandates that advisers establish chief
compliance officers who report directly
to the mutual fund board. The capstone
however of the SEC’s effort to protect
investors and deal with a serious
breakdown in management controls
were the two conditions adopted on July
27, 2004 that are the subject of this
Remand, that fund boards have at least
75% independent directors and an
independent chairman.
The Agency’s purpose in proposing
the conditions was to protect investors
from serious harm and from a
breakdown in funds’ existing controls
and structure. In addition to investor
protection, I and the other majority
Commissioners were also very
concerned that the mutual fund
industry as a whole was under siege by
the acts of a greedy few. Investor
confidence in the integrity of mutual
funds was damaged and needed to be
restored. Our mission also to protect the
integrity of the financial sector was
being challenged. It is worth noting that
the industry association the Mutual
Fund Directors Forum also supports the
rules because of their concern for the
overall health of the industry, even
though a significant fund family was
against the rule.
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III. The Court of Appeals Upheld the
SEC’s Authority To Enact the Rules and
Approved of the Rationale
The two new conditions adopted by
the SEC were challenged by the
Chamber of Commerce, which
submitted a petition for review to the
U.S. court of Appeals of the District of
Columbia Circuit. On June 25, 2005, the
Court of Appeals issued its decision.
The decision has been regularly been
mischaracterized in the press.
The DC Circuit Court stated on page
2 of its opinion, ‘‘We hold that the
Commission did not exceed its authority
in adopting the two conditions, and the
Commission’s rationales for the two
conditions satisfy the Administrative
Procedures Act.’’ The decision is
meaningful because it clarifies the
Commission’s authority to regulate the
corporate governance of mutual funds
under section 6(c) of the Investment
Company Act and dispels the notion
that such issues are left entirely to state
law.
As the Court holds on page 12 of its
opinion, ‘‘The Commission reasonably
concluded that raising the minimum
percentage of independent directors
from 50% to 75% would 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.’’ The Court also upheld the
Commission’s conclusion that an
independent chairman provides ‘‘a
check on the adviser, in negotiating the
best deal for shareholders * * * and in
providing leadership to the board that
focuses on long-term interests of
investors.’’
In considering both the 75% rule and
the independent chairman requirement,
the Court held, on page 12 of the
opinion, ‘‘In sum, the Chamber points to
nothing in the Investment Company Act
that suggest the Congress restricted the
authority of the Commission to make
‘precautionary or prophylactic
responses to perceived risks’ and the
Commission’s effort to prevent future
abuses * * * was NOT arbitrary,
capricious, or in any way an abuse of its
discretion. * * *’’
IV. The Commission Has Carefully
Followed the Directions of the Remand
With Respect to the Finding That the
Commission Did Not Adequately
Consider the Costs Imposed Upon the
Funds by the Two Challenged
Conditions
The Court remanded to the
Commission two deficiencies that it
identified in the rule making. First, the
Court held that, in connection with the
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statutory obligation to consider whether
the conditions will promote efficiency,
competition and capital formation, the
Commission did not adequately
consider costs associated with both the
75 percent independent board and the
independent chairman conditions.
Secondly, the Court stated that the
Commission did not give adequate
consideration to an alternative called
the ‘‘disclosure alternative.’’
The Commission in its Response to
the Court’s Remand has carefully
considered the adequacy of the existing
record and the need for further fact
finding to properly consider and to
follow the Court’s direction on remand.
Given that the Commission labored for
over one year in studying the matter, it
is not surprising that the existing record,
developed through full notice and
comment procedures, is vast and ample.
Specifically the Commission had also
previously sought and received
comment on the costs of the two
conditions and had further elicited
comment on the disclosure alternative.
It is clear under Circuit cases that the
agency is free on remand to determine
whether supplemental fact-gathering is
necessary and sufficient to address on
remand the court-identified
deficiencies. Accordingly, after careful
review, the Commission has determined
that the existing record and information
publicly available at the time of the
original adoption is a sufficient base on
which to consider and follow the
Court’s directions on remand.
The proof of the sufficiency of the
existing record is in the careful
estimates of costs and calculations
performed in the Commission’s
Response. The estimates and ranges
track exactly the directions in the
Court’s Opinion for formulating the
estimates for the costs of the two
conditions. Conservative estimates have
been made and cushions to cover all
possible costs have been added to
calculations.
The key conclusion is that under the
most conservative estimates of costs for
implementing the conditions, the total
costs are minimal under any measure.
As such, there is no reasonable basis for
believing that any additional fact
finding would alter in any way this
conclusion. Indeed, as allowed for
consideration under Circuit cases, the
Commission’s Response cites recent
studies subsequent to the original
adoption that confirm the original
information. (See Response, FN 69)
The Commission also reanalyzes and
discusses why the notice alternative is
deficient. As explained, this alternative
was previously considered and
implicitly rejected. The Court’s
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directions to expressly consider the
alternative is accomplished in a full and
adequate manner in the Commission’s
response.
V. Dispatch, Focus, and Diligence Does
Not Equate to Inattentiveness or Failure
to Analyze Carefully
There has been a consistent reporting
in the press that advocates for the
Chamber’s position claim that any
action in response to the Court’s remand
that does not include a new notice and
comment period is somehow improper
and disrespectful to the Court of
Appeals. Quite simply, that contention
is absurd on its face. Immediate
attention and diligence and a focusing
of staff resources to respond to the
Court’s Remand shows the utmost in
respect and in placing the matter at the
highest level of priority.
Quite frankly, this Agency prides
itself in meeting impossible deadlines
and turning around prodigious amounts
of work in short time frames. Examples
are innumerable. However, one clear
example occurred during the last days
of former Chairman Pitt’s tenure from
January 22, 2003 to January 31, 2003. In
a ten day period, the Commission (with
the same four Commissioners that
enacted the rule in question, except for
Chairman Donaldson), enacted no less
than ten rulemakings, several on a twice
a day schedule, and several being final
rules or comments. The day after
WorldCom filed a surprise restatement,
this Agency had filed a lengthy
complaint to move swiftly to protect
assets for victims of fraud. This Agency
never missed a deadline in fulfilling
Congress’ mandates to implement the
requirements of Sarbanes Oxley,
resulting in more rulemakings in one
year alone, during 2003, than in any
other decade in its history.
The ultimate refutation of the
accusation to a rush to judgment is the
ostensible high quality of the
Commission’s Response and the
analysis therein.
VI. There Is an Absolute Urgency in
Moving Forward To Implement the
Protections Judged Necessary by This
Agency
This Commission has concluded that
serious threats exist to mutual fund
investors. The Commission’s judgment
is that extra prophylactic measures in
the two conditions involving the 75%
independent board and the independent
Chair will add significant benefits to
investor protection to combat the types
of fraud that have been uncovered. The
Court in its Opinion stated that such
conclusions were reasonable and that
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there exists ‘‘no basis upon which to
second guess that judgment.’’
The Commission therefore has a
binding obligation to implement as
expeditiously as possible the subject
rule to protect investors and also to aid
sustaining investor confidence resulting
in protecting the integrity of the
markets. Quite simply, a variation of an
old adage applies in this context:
‘‘Investor protection delayed is investor
protection denied.’’ To not move
quickly would be a violation of the duty
of the Agency to protect investors and
the markets.
There have been accusations that the
Commission is doing something for that,
for lack of a better term, is ‘‘sneaky’’ or
devious in responding to the Court
within the last days of this particularly
constituted Commission. Again, this
accusation is patently absurd. The
Commission is not doing anything
‘‘under the cover of darkness.’’ The
Commission acknowledges the fact that
Chairman Donaldson is at the end of his
service. This fact only adds to the
urgency in that the full Commission that
has thoroughly studied the issue should
be the one to deal if possible with
proper care with the Court’s instructions
on Remand.
There is also another clear set of facts
that the Commission must deal with. If
it did not act expeditiously in
responding carefully and fully to the
Court’s Remand, a state of limbo will
occur as to this rulemaking. There can
be no prediction when the new
Chairman and possibly other
Commissioners will be nominated by
the President and confirmed by the
Senate. What is certain is that many
mutual funds that are in the midst of
implementing the new rules will be
‘‘left hanging’’ and may have to incur
unnecessary or additional costs as they
await finality on these rules.
Ultimately, if the Commission were
not to have acted with speed and
dispatch in responding to the Court’s
Remand, investor protection and
integrity of the markets will not be
served.
I for one must support the protection
of investors and our markets.
Therefore, I conclude that the
Commission had no choice but to act
expeditiously and quickly in responding
to the Court’s Remand. The Commission
was also in a position to prepare a
thoughtful and quality response in short
order.
Indeed, anyone who supports another
course of action by the Commission
risks hampering investor protection and
places other interests above investors
and the overall health of the markets.
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I vote in favor of the proposed
response to the Court’s Remand and I
support all of the substantive contents
in the proposed response.
Dissent of Commissioner Cyntha A.
Glassman to the Commission Response
To Remand by Court of Appeals
Investment Company Governance
I disagree with this rush to respond to
the Court’s remand of the ‘‘independent
chair’’ rulemaking in the strongest
possible terms. Last fall, the Chamber of
Commerce of the United States of
America challenged two provisions in
the Commission’s mutual fund
governance rule, adopted over my and
Commissioner Atkins’ dissent, in July
2004, namely, the requirements that
investment companies relying on our
exemptive rules have an independent
chair of the board of directors and a
board composed of at least 75 percent
independent directors. Last Tuesday,
June 21st, the United States Court of
Appeals for the District of Columbia
Circuit granted the Chamber’s petition
requesting the Court to set these
requirements aside and prohibit the
Commission from implementing and
enforcing them. In its unanimous
decision, the Court held that the
Commission violated the Administrative
Procedures Act, or the APA, by failing
adequately to consider the costs mutual
funds would incur in order to comply
with the conditions and failing
adequately to consider at least one
reasonable proposed alternative to the
independent chair condition. The Court
therefore remanded the proceeding to
the Commission to address the
deficiencies identified by the Court.
In my view, a prudent response to the
Court’s mandate would be for the
Commission to seek public comment on
the issues identified by the Court as
violating the APA. Instead, if this action
is approved, the agency, through a
chairman who is resigning effective
tomorrow, will have elevated form over
substance once again.
On the same day that the Court issued
its decision, I received an e-mail
message from the Chairman’s chief of
staff informing me, without prior
consultation, that the staff had reviewed
the Court’s opinion and ‘‘concluded that
the court’s concerns can be addressed
on the basis of the record already before
the Commission.’’ As such, the
Chairman determined that this matter
would be on today’s open meeting
agenda—a mere week following the
Court’s remand. While the Commission
has an excellent and hardworking staff,
it is simply not possible to conduct a
thorough review ‘‘of the record’’ in this
time frame. The fact that the decision to
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hold today’s meeting was made just
hours after the issuance of the Court’s
decision further demonstrates the
cursory nature of the ‘‘review.’’ It does
not require a clairvoyant to discern the
real reason for the rush to judgment—
indeed, much to my surprise, the
proposed release openly states it—the
Chairman has announced his
resignation effective tomorrow and
therefore this meeting must be held
today. What is not expressly stated in
the release, but is equally clear, is the
majority’s fear that in the absence of the
Chairman’s participation, the rule will
not be implemented. This concern,
whether real or imagined, does not
justify ignoring the Commission’s
obligation to address properly the APA
deficiencies found by the Court.
Before addressing some of the
substantive problems with the proposed
release, it is important for the public to
understand the procedural deficiencies
surrounding this proceeding. To begin,
the procedure employed by the
Chairman in placing this matter on the
agenda today was unusual. The Code of
Federal Regulations requires that we
provide a ‘‘sunshine notice’’ of an open
meeting. An individual Commissioner
known at the ‘‘duty officer’’ typically
signs this notice. The designation of
duty officer rotates weekly among the
Commissioners, but not the Chairman.
Last week, I was the designated ‘‘duty
officer.’’ Nonetheless, I did not learn
until the next day that the Chairman
had instead opted to serve as the duty
officer for this matter and ‘‘sign off’’ on
the notice. To the best of my knowledge,
the Chairman has never previously
served as duty officer during his tenure
and his decision to do so—in this matter
only—is without precedent.
A claimed rationale for proceeding on
the matter today is that it is ‘‘important
and appropriate for the same five of us
to address the issued raised by the Court
on remand’’ because of our ‘‘unique
familiarity with these matters.’’ This is
ludicrous—I do not believe and I
challenge the majority to find any
support for the notion that only those
involved in a particular rulemaking
have enough knowledge to effect any
changes to it. Indeed, if this observation
were true, the agency’s regulations
would be set in stone and could never
be modified once there was a change in
the Commission’s constitution.
More disturbing is the statement in
the action memorandum circulated with
the proposed release ‘‘request[ing] that
any concurring or dissenting statements
be circulated prior to the meeting’’
today. This is yet another new
procedure unique to this proposal. The
stated basis for this request is to allow
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any such statement to be published
contemporaneously with the release,
because it is contemplated that the
release will be adopted today and
published before the Chairman’s
departure. What this really shows is that
the issues have been ‘‘pre-judged,’’
which is a violation of our duty as
Commissioners and yet another reason
to believe that this matter will not
survive a legal challenge. In any event,
as a practical matter, no ‘‘advance copy’’
of a dissent was possible given the
compressed time frame for this meeting
and the fact that the staff continued to
revise the proposed release up until and
including yesterday evening. I request
that this statement accompany the
release and serve as my dissent pending
an opportunity to provide a more formal
dissent after I have had an opportunity
to review the release as adopted.
Turning to the proposed release, on
Friday evening, June 24, the staff
circulated a 27-page draft of it. This
draft, produced a mere three days after
the Court’s opinion, contains what can
only be described as a back of the
envelope calculation of costs that rest
largely on the staff’s ‘‘estimates’’ and
‘‘judgment’’—two buzzwords used
repeatedly in the release. Subsequent
drafts were circulated late Monday and
Tuesday evening. Numerous revisions
were made to each draft to which I have
not been afforded adequate opportunity
to review. I have no way of determining
whether there is any validity for the cost
analysis and the context for these costs.
For example, how do these costs relate
as a percentage of a fund’s total
expenses?
I need not dwell on the failings of the
proposed release. It is sufficient to state
that the release is an assembly of false
statements, unsupported assumptions,
flawed analysis, and misinterpretations.
However, one often-repeated statement
in the release—that the Commission can
address the Court’s concerns on the
basis of the record already before the
Commission—must be corrected. To be
clear, the Commission cannot address
the Court’s concerns on the basis of the
record already before the Commission. It
cannot address the costs because,
contrary to whatever representations the
staff makes today, the Commission has
repeatedly and consistently represented
to the Court, to Congress and to the
public that it has ‘‘no reliable basis for
estimating’’ the costs. This statement,
both in connection with the costs
associated with electing independent
directors, and with the costs incurred by
an independent chair hiring staff,
appears repeatedly in the proposing and
adopting release, in the Commission’s
brief to the Court, and most recently, in
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the April 2005 staff report submitted to
the Congress which submission was
mandated by the Consolidated
Appropriations Act of 2005. It strains all
credibility to believe that the
Commission, professing for the past year
and a half its lack of a reliable basis, has
mystically within the past week been
able conclusively to estimate costs
associated with the rule.
More fundamentally, the Commission
cannot address the costs associated with
the independent chair’s hiring of staff
and experts because it expressly
declined to ask for comment on this
issue. Specifically, in part V.B. of the
proposing release, published in January
2004, the Commission recited that the
proposed release would require: (1) An
independent director to be chair; (2)
directors to perform an annual
evaluation of the board; (3) independent
directors to meet in executive session at
least quarterly; and (4) independent
directors be given specific authority to
hire employees. Immediately thereafter,
the release states: ‘‘We request comment
on the costs of the first three items
above, and on whether boards would
choose to hire employees.’’ Although
the last version of the proposed release
I received last night continues to state
that we ‘‘specifically sought and
received comment’’ on this cost, it is
indisputable that we have never
solicited comment on the costs
associated with the hiring of staff—one
of the very issues that the Court has now
directed the Commission to address on
remand.
In an apparent effort to bolster the
argument that the Commission had, in
fact, considered costs based on the
record before it, the proposed release
indicates that information ‘‘publicly
available at the time we originally
adopted the amendments’’ is sufficient
to base the Commission’s current
discussion of costs. The latest version of
the release now also includes a passing
reference to ‘‘supplementary public
information’’ without elaboration. It is
curious indeed that in proposing this
release the Commission has forgone
examining subsequent data of real costs
that mutual funds have incurred since
the adoption of this rule last year as
these funds prepare for the rule’s
implementation date. It is even more
curious that the purported basis to
exclude actual data rests on the theory
that our estimate of costs is on the ‘‘high
end of the range’’ rendering an
examination of actual data unnecessary.
This logic is backwards—it is the actual
data which makes estimates
unnecessary. As an economist, I cannot
accept estimates and ‘‘best judgments’’
to support a cost/benefit analysis when
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actual costs are readily available and
can easily be obtained through a request
for public comment.
Likewise, the Commission cannot on
the basis of the record before it address
the alternative proposal identified by
the Court that each fund be required
prominently to disclose whether it has
an inside or an independent chair and
thereby allow investors to make an
informed choice. When the Commission
initially sought comment at the proposal
stage, it did not seek specific comment
on whether disclosure was a viable
alternative. Rather, the Commission
only asked generally for comment on
alternatives, followed by a series of
specific alternatives that did not include
disclosure. Nonetheless, today’s
proposed release attempts to suggest
that robust comment on a disclosure
alternative was solicited, citing two
comment letters that briefly mention—
and I might add support—disclosure as
an alternative. It is noteworthy that the
staff, in compiling for us a summary of
the 200 plus comment letters to this
rulemaking, did not include any
reference to disclosure as alternative.
This is because this issue simply was
not addressed in more than a handful of
these letters.
As the Commission conceded in its
brief to the Court, the truth of the matter
is that the Commission did not consider
‘‘all’’ alternatives in adopting the rule
because, in the majority’s view, the
Commission was not required to do so.
Implicit in the single paragraph in the
Commission’s brief devoted to this
significant issue is the
acknowledgement that no consideration
was given to a disclosure alternative,
even though this alternative provides
the Commission with a rule-making
option that, as the Court observed, is
‘‘neither frivolous nor out of bounds.’’
The proposing release rejects
disclosure as an inadequate alternative
on the basis that it would not protect
investors from the ‘‘potential abuses
inherent in the conflict-of-interest
transactions permitted under the
exemptive rules.’’ In its remand opinion
however, the Court dismisses this
argument as irrelevant, finding instead
that the fact the Congress in the
Investment Company Act required more
than disclosure with respect to some
matters governed by that statute does
not mean that Congress deemed
disclosure insufficient with respect to
all matters. Without soliciting comment
on this issue, we have no basis to
discern whether the public would or
would not find disclosure meaningful.
Nonetheless, the release concludes that
disclosure would not be meaningful,
citing a recent speech in which I
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questioned the length of fund
prospectuses. Not only does this
argument misinterpret what I said, but
it leads to the illogical conclusion that
once a prospectus reaches a certain
length, it is full and therefore no
additional information can be added.
The proposed release indicates that a
reason for proceeding today is because
expedited consideration is necessary in
order to protect investors. For the
reasons stated above, this statement is
completely disingenuous. The case has
never been made to my satisfaction that
the benefits of this rule are more than
cosmetic. In this regard, the Chairman’s
reference to market timing scandals at
mutual funds with an interested chair as
warranting the rule is misplaced. The
share of these scandals at funds with
interested chairs versus independent
chairs was proportionate to their share
of funds. In any event, in my view,
protection of investors compels that we
carefully consider the costs and
alternatives before rushing to judgment.
To allow this open meeting to proceed
as if the Commission can simply fill in
the blanks for APA deficiencies, without
requesting public comment on these
significant issues, makes a mockery of
the process. Today’s action is nothing
more than window-dressing. It violates
the spirit, if not the letter of the Court’s
opinion, which in directing the
Commission to address the deficiencies,
clearly contemplated that the
Commission would do so by applying
‘‘its expertise and its best judgment’’ to
bear. Rather than attempt in good faith
to respond appropriately to the Court’s
direction, the Chairman has hastily
scheduled this meeting designed to give
the appearance that the Commission has
judiciously considered its prior APA
deficiencies, but in reality, is simply an
attempt to obtain the same result
without any serious examination of the
costs associated with the rule and the
alternatives available.
One additional point is worth
mentioning. While the Chairman has
refused to allow a public comment
period for this proceeding, the public
has not been silent in the past week.
The Commission has received letters
and statements from former
Commissioners (including at least one
Chairman), former staff, and trade
associations, and there has also been
much media coverage. Many of these
public comments voice their opposition
to the manner in which this proceeding
has been conducted. They question the
timing of this proceeding, the lack of
public input into the process, and the
likely long-term damage that will result
to the agency as a result of operating in
this fashion. While we are responding to
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these letters in our release, it is my
understanding that the letters will not
be posted to our Web site for public
review.
Accordingly, for all the foregoing
reasons, I am compelled to vote against
the proposal. In closing, I would like to
take this opportunity to apologize. First,
to the Court, for the agency’s failure to
respond appropriately to the Court’s
directive to undertake a meaningful
review. Second, to those staff members
who were uncomfortable having to
participate in this exercise. And third,
to the public, which must continue to
live with the uncertainty surrounding
the legality of a rule that was adopted
in violation of the APA and, after having
already been stricken by a Court, will
most certainly be challenged again as a
result of our action today.
I have one question. The most recent
version of the release has added a new
footnote 15 which states that: ‘‘Even
prior to our having issued this Release,
there have been reports that additional
legal proceedings may result from our
action today. Accordingly, we are
instructing our Office of the General
Counsel to take such action as it
considers appropriate to respond to any
proceedings relating to this
rulemaking.’’ I have never seen this
before.
• Have we ever done this before?
• What does it mean?
• What is the effect?
Addedum June 30, 2005
These dissenting remarks are based on
the draft release circulated Tuesday
evening, June 28, 2005 for the open
meeting held at 10 a.m. on June 29,
2005. The final post-meeting release has
been changed by the majority
apparently in reaction to some of the
procedural deficiencies noted in my
dissent. These changes do not cure
those deficiencies, however they may
make some of my references at the
meeting to statements in the release
appear inapposite. As an aside, footnote
15, which the general counsel refused to
explain in response to my questioning at
the open meeting, has now been
renumbered footnote 14.
Dissent of Commissioner Paul S. Atkins
to the Commission Response To
Remand by Court of Appeals
Investment Company Governance
On June 29, 2005, three of the five
commissioners (the ‘‘majority’’) of the
U.S. Securities and Exchange
Commission (‘‘SEC’’ or ‘‘Commission’’)
voted to reaffirm a rulemaking 1 eight
1 Investment Company Governance, Investment
Company Act Release No. 26985 (June 30, 2005)
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days after the United States Court of
Appeals for the District of Columbia
Circuit (the ‘‘Court’’) remanded the
rulemaking to the Commission.2 I
dissented from the majority’s action.
Although I have substantive objections
to the rule amendments that the
majority reaffirmed,3 my concerns about
today’s actions of the majority run much
deeper. The majority’s action is the
product of a gravely flawed process,
which is far from the informed
deliberation that should have preceded
any final action in response to the
Court’s remand. My concerns are set
forth below.
Background
Last year, the Commission, in a split
vote, adopted amendments to ten
widely relied-upon exemptive rules in
order to mandate a uniform corporate
governance structure for all investment
companies.4 The three commissioners
who voted in favor of the amendments
last year are now reaffirming the
adoption of these amendments. In the
interim, the Chamber of Commerce of
the United States of America (the
‘‘Chamber’’) petitioned the Court for a
review of two of the amendments.5 On
the morning of Tuesday, June 21, 2005
the Court granted, in part, the
Chamber’s petition and remanded the
matter to the Commission to address
two violations of the Administrative
Procedure Act (‘‘APA’’)6 that the Court
identified in the process by which the
Commission had approved the rules.
Specifically, the court held that the
Commission had (i) ‘‘violated its
obligation under 15 U.S.C. 80a–2(c), and
therefore the APA, in failing adequately
to consider the costs imposed upon
funds by the two challenged
conditions,’’ and (ii) violated the APA
by failing to consider a disclosure based
(‘‘Remand Release’’). Because at the time of this
writing (2:30 p.m. on June 30, 2005) I do not yet
have a final version of the release, this dissent refers
to the draft release circulated on June 27, 2005.
2 Chamber of Commerce of the United States of
America v. Securities and Exchange Commission,
No. 04–1300, slip op. (D.C. Cir. June 21, 2005)
(‘‘Slip Opinion’’).
3 These concerns are set forth in the dissent that
Commissioner Glassman and I filed when the rules
were adopted. See Dissent of Commissioners
Cynthia A. Glassman and Paul S. Atkins to
Investment Company Governance (July 27, 2004)
[69 FR 46390 (Aug. 2, 2004)] (available at: https://
www.sec.gov/rules/final/ic-26520.htm#dissent)
(‘‘Adoption Dissent’’).
4 Investment Company Governance, Investment
Company Act Release No. 26520 (July 28, 2004) [69
FR 46378 (Aug. 2, 2004)] (‘‘Adopting Release’’).
5 The amendments require that, if a fund relies on
one of the exemptive rules, the fund must have a
board of directors with (i) no less than 75 percent
independent directors, and (ii) a chairman who is
an independent director.
6 5 U.S.C. 551 et seq.
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alternative to the independent chairman
condition.7
A summary of the events that
followed the issuance of the Court’s
opinion provides a window into the
nature of the deliberation that preceded
the majority’s reaffirmation of the rule
amendments.8 On Tuesday evening, less
than twelve hours after the Court had
issued its opinion, the Chairman of the
Commission scheduled the matter for a
vote on June 29, 2005. The Chairman’s
chief of staff explained in an e-mail that
the staff had ‘‘concluded that the court’s
concerns can be addressed on the basis
of the record already before the
Commission.’’ That same evening, the
Chairman displaced the designated duty
officer for the week to authorize
unilaterally the issuance of a public
notice of the meeting.9 This ‘‘sunshine
act notice’’ was issued the next
morning.10
On Friday evening, less than eighty
hours after the Court’s decision, the
staff, recommending against additional
fact-gathering, provided the
Commissioners with a 27-page draft
release that purported to analyze the
issues remanded by the court. The staff
typically provides their
recommendations to the Commission at
least two weeks (and often thirty days)
before the meeting at which they are
scheduled for consideration. On
Monday evening, shortly after asking
the Chairman to remove the item from
the Commission’s calendar in order to
seek additional comment, a
substantially revised draft of the release
was distributed. We were instructed by
the Chairman’s staff to submit any
dissenting statements by noon the
7 Slip
Opinion, supra note 2, at 17.
timeline laying out the events of the past week
is attached to this dissent. See Exhibit A. Even
under normal circumstances, the Commission could
not conduct a meaningful analysis within eight
days, as the majority claims it has done. During the
eight day period at issue, the commissioners and
their staffs moved to a new headquarters building,
which meant that they had no access to office space
or computers for more than two of the eight days.
In addition, the Chairman and two commissioners
were out of the country for much of this period.
9 The Commission’s Rules of Practice provide for
the delegation of certain matters to a ‘‘duty officer.’’
See 17 CFR 200.43. ‘‘To the extent feasible, the
designation of a duty officer shall rotate, under the
administration of the [Commission’s] Secretary, on
a regular weekly basis among the members of the
Commission other than the Chairman.’’ 17 CFR
200.43 (a)(2) (emphasis added). I can recall only one
other instance from my years as a Commissioner
and, before that, on the Commission staff, when a
Commission chairman has taken the place of the
designated duty officer to authorize Commission
action. I am not contending that the Chairman’s
acting as duty officer was illegal, simply that it was
irregular and evidenced the hurried and prejudged
nature of the process.
10 Available at: https://www.sec.gov/news/
openmeetings/ssacmtg062905.htm.
8A
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following day.11 On Tuesday, after the
close of business, we received the draft
of the release that would be considered
at the Commission meeting the next
morning.
Thus, before the ink on the Court’s
opinion was even dry, the die was cast
for the predetermined result of the
Commission’s deliberations. There was
never a serious attempt made to solicit
my views or incorporate them into the
Commission’s release. The procedural
flaws that characterized this process did
not mitigate, but rather compounded,
the flaws in the adoption process that
were identified by the Court. This
peculiar sequence of events is a very
fitting capstone on this rulemaking
process in which the majority’s selfdescribed ‘‘logic and experience and
anecdotal evidence’’ 12 has counted
more than anything else.
Analysis of Costs
After protesting repeatedly over the
past year and a half about the
Commission’s inability to conduct an
analysis of costs, the majority claims to
have done just that in about a week.
When the majority adopted the rule, it
described the costs as minimal,
explained that our staff had no ‘‘reliable
basis’’ for estimating costs, and
complained that doing so would be
‘‘difficult.’’ 13 After the rule’s adoption,
Congress directed the Commission to
submit a report justifying the rule.14 The
staff report,15 which the majority
submitted in April 2005 over
11 Because I had not yet seen the final pre-meeting
version of the release, I was unable to comply.
12 Open Meeting to Consider Investment
Company Governance Amendments (Jan. 14, 2004)
(Webcast available at: https://www.sec.gov/news/
openmeetings.shtml) (statement of Commissioner
Harvey Goldschmid) (‘‘there are moments where
logic and experience and anecdotal evidence
compels your conclusions and this for me is one of
those areas . . .’’).
13 See Adopting Release, supra note 4, at VI.B
(‘‘Costs’’). In addition, the ‘‘Consideration of
Promotion of Efficiency, Competition and Capital
Formation’’ section of the adopting release, which
the Court found to be deficient (Slip Opinion, supra
note 2, at 17), contained only two sentences of
analysis. See Adopting Release, supra note 4, at
Section VIII. This is peculiar given the majority’s
belief that these amendments will have a profound
effect on the market. See, e.g., Remand Release,
supra note 1, at text accompanying note 13 (‘‘It is
important that we avoid postponement of the
compliance date [of the investment company
governance amendments] and the attendant
potential harm to investors and the market that
would result.’’).
14 See Consolidated Appropriations Act, 2005,
Pub. L. No. 108–447, 118 Stat. 2809, 2910 (2004).
15 Staff Report, EXEMPTIVE RULE
AMENDMENTS OF 2004: THE INDEPENDENT
CHAIR CONDITION: A REPORT IN ACCORDANCE
WITH THE CONSOLIDATED APPROPRIATIONS
ACT, 2005 (April 2005) (available at: https://
www.sec.gov/news/studies/indchair.pdf) (‘‘Staff
Report’’).
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Commissioner Glassman’s and my
objections,16 continued to insist that
costs were ‘‘minimal,’’ ‘‘speculative,’’ or
could not be estimated.17
The order of an unanimous court
should have chastened the Commission,
but the majority’s Remand Release only
perpetuates the cavalier attitude with
which we have approached our
obligations in this rulemaking.18 While
the Court, appreciating the difficulty of
estimating costs in this area, did not
demand perfection, it did direct us to do
the best we can.19 I respectfully submit
that our eight-day reconsideration of the
rule does not meet this standard.20
16 See Letter from Commissioners Cynthia A.
Glassman and Paul S. Atkins to the Honorable Thad
Cochran, Chairman, Senate Committee on
Appropriations (Apr. 29, 2005) (available at: http:/
/www.sec.gov/news/speech/spch050205cagpsa.htm.
17 Staff Report, supra note 15, at 60–61.
18 Arguably, the Commission should already have
been chastened by embarrassing miscalculations of
cost in connection with earlier rulemakings. In
connection with the adoption of regulations to
implement Section 404 of the Sarbanes-Oxley Act,
for example, ‘‘we estimated the aggregate annual
costs of implementing Section 404(a) of the
Sarbanes-Oxley Act to be around $1.24 billion (or
$91,000 per company).’’ Management’s Reports on
Internal Control Over Financial Reporting and
Certification of Disclosure in Exchange Act Periodic
Reports, Securities Act Release No. 8238 (June 5,
2003) [68 FR 36636 (June 18, 2003)] at Section V.A.
A subsequent industry report found the
implementation costs to be ‘‘more than 20 times
greater than our 2003 estimates.’’ Alex Davern, et
al., SARBANES–OXLEY SECTION 404: THE
‘‘SECTION’’ OF UNINTENDED CONSEQUENCES
AND ITS IMPACT ON SMALL BUSINESS (Feb.
2005), at 2 (available at: https://www.aeanet.org/
governmentaffairs/AeASOXPaperFinal021005.asp).
See also Financial Executives International, Press
Release: Sarbanes-Oxley Costs Exceed Estimates
(Mar. 21, 2005), at 1 (available at: https://
www.fei.org/files/spacer.cfm?file_id=1498) (based
on a survey of 217 public companies with average
revenues of $5 billion, FEI found that ‘‘[t]heir total
cost of compliance averaged $1.34 million for
internal costs, $1.72 million for external costs and
$1.30 million for auditor fees’’). Additionally,
Congress has reprimanded the Commission in the
past for its failure to conduct the type of analysis
that the Court found flawed. See Gramm-LeachBliley Conference Report (Nov. 1, 1999) (available
at: https://banking.senate.gov/conf/somfinal.htm), at
Title II.A) (‘‘In addition, during the rulemaking
process, the SEC must also make a number of
findings. When considering whether such an action
is in the public interest, the SEC must also consider
whether the action will promote efficiency,
competition and capital formation * * * The
Conferees note that the SEC’s record in
implementing section 3(f) has failed to meet
Congressional intent. The Conferees expect that the
SEC will improve in this area.’’).
19 The Court stated specifically that the difficulty
of the task ‘‘does not excuse the Commission from
its statutory obligation to determine as best it can
the economic implications of the rule.’’ Slip
Opinion, supra note 2, at 15.
20 I cannot, without more information and more
time, take a position on the quality of particular
estimates in the majority’s cost-benefit analysis, but
the majority’s estimates may not be conservative.
For example, how would the majority’s estimates
change if it used average instead of median salary
information to calculate the cost of new
independent directors? See Remand Release, supra
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The Remand Release purports to
undertake a consideration of the
deficiencies identified by the Court on
the basis of information in the existing
record and information that was
publicly available at the time of
adoption.21 This approach is
problematic on several fronts. First, and
most importantly, some funds have
already begun to comply with the fund
governance rules. Instead of relying on
estimates, the Commission could easily
conduct a survey asking questions about
actual costs to comply with the rules.
Why would we not seize on this
fortuitous opportunity to utilize current,
relevant data? 22 In this regard, just two
days ago, the ICI volunteered to assist
the Commission with obtaining this
information from its widespread and
representative membership.23
Second, the Remand Release
implicitly acknowledges that the
rulemaking record contained critical
gaps regarding costs. Recognizing this
flaw, the majority haphazardly searches
for additional information that
happened to be publicly available at the
time of the rule’s adoption to attempt to
justify its actions.24 The majority takes
note 1, at text following note 28. Do the salary
figures cited include additional costs of expenses
related to traveling to board meetings?
21 See Remand Release, supra note 1, at text
preceding note 11. The majority purports to look at
‘‘supplementary public information available
subsequent to our original adoption of the
amendments’’ only to ‘‘confirm[] the information
available at the time of our original adoption.’’ See
Remand Release, supra note 1, at note 11. In several
instances, however, the majority appears to rely
only on post-adoption sources for cost estimates.
See Remand Release, supra note 1, at note 32 (for
cost of recruiting an independent director, citing J.
Bel Bruno, ‘‘Recruiter Picked for HP Search,’’ THE
PHILADELPHIA INQUIRER, Feb. 18, 2005, at C03);
Remand Release, supra note 1, at note 43 (for
percentage increase in director compensation
during 2004, citing MPI Bulletin, ‘‘More Meetings,
More Pay: Fund Directors’’ Compensation Increases
13% as Workload Grows’’ (Apr. 2005) (available at
https://www.mfgovern.com)).
22 The majority cited post-adoption materials
when doing so served its purposes. See, e.g.,
Remand Release, supra note 1, at note 69 (citing,
for proposition that ‘‘[r]ecently industry experts
have similarly noted that the quantitative effect of
the independent chairman condition will be
modest,’’ Kathleen Pender, ‘‘SEC’s Fund Rule,
Revisited,’’ San Francisco Chron., June 23, 2005, at
C1 (quoting fund governance analyst Meyrick Payne
as estimating ‘‘that the industry-wide cost of having
independent chairs, ‘at an absolute maximum, is
$18 million’ a year, which is ‘a drop in the bucket’
for an industry with $8 trillion in assets.’’).
23 See Letter from Elizabeth R. Krentzman,
General Counsel, Investment Company Institute, to
Jonathan G. Katz, Secretary, SEC (June 27, 2005)
(‘‘ICI Letter’’), at 2.
24 Given that the majority supplements the record,
it is not clear why they cite cases that stand for the
proposition that ‘‘if the existing record is a
sufficient base on which to address on remand the
court-identified deficiencies, additional notice and
comment procedures are not required.’’ See
Remand Release, supra note 1, at note 9 (citing
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a sort of ‘‘judicial notice’’ of the newlydiscovered information by treating it as
irrefutable fact and uses it to ratify its
prior decision.25
The majority’s primary discovery to
supplement the flawed rulemaking
record was a two-page newsletter,
which summarizes the results of a
nonpublic survey about director
compensation conducted by a private
consulting firm.26 Incidentally, the
Commission staff did not obtain a copy
of the underlying nonpublic survey,
apparently because doing so would
contradict the majority’s intention to
rely only on the purportedly adequate
Sierra Club v. EPA, 325 F.3d 374, 382 (D.C. Cir.
2003); National Grain and Feed Ass’n v. OSHA, 903
F.2d 308, 310–11 (5th Cir. 1990); AT&T Wireless
Servs., Inc. v. FCC, 365 F.3d 1095, 1103 (D.C. Cir.
2004). Each of these cases is also distinguishable on
the grounds that there was no dissent within the
decisionmaker. Both the Environmental Protection
Agency and the Occupational Safety and Health
Administration are led by a single administrator
and the action at issue in the third case was reached
by the decision of an unanimous Federal
Communications Commission. The instant matter is
distinguishable; the Commission’s action is the
product of a divided Commission, two members of
which have continually expressed concerns about
the process by which the determination on how to
proceed was reached.
25 The majority also relies heavily on its own
experience for specific estimates that are central to
its cost-benefit analysis. See, e.g., Remand Release,
supra note 1, at text preceding note 36 (‘‘Based
upon our experience, we estimate that, on average,
the new independent directors will use additional
independent legal counsel services a total of 30
hours a year.’’); Remand Release, supra note 1, at
text following note 56 (‘‘In our judgment,
independent chairmen will hire no more than, on
average, two staff employees, consisting of one full
time senior business analyst and one full time
executive assistant.’’); Remand Release, supra note
1, at text following note 61 (‘‘Based upon our
experience, we estimate that, on average, the
independent chairman will use independent legal
counsel a total of 50 hours a year more under the
amendments.’’). The use of the Commission’s
judgment and experience is appropriate, but where,
as here, the Commission’s judgment and experience
are the source of the basic elements of its cost
analysis, members of the public should have the
opportunity to counter with estimates from their
own judgment and experience and with empirical
data.
26 Management Practice Inc., ‘‘More Meetings
Means More Pay for Fund Directors’’ (Apr. 2004)
(‘‘April 2004 MPI Bulletin’’). The Remand Release
cites to this or one of three other MPI Bulletins
approximately seven times. The Remand Release
also cites two newspaper articles that quote from
Meyrick Payne, a senior partner of MPI. See
Remand Release, supra note 1, at note 64 (citing
Beagan Wilcox, ‘‘Wanted: Independent Chairmen,’’
Board IQ, July 6, 2004 (citing estimate of Meyrick
Payne, senior partner, Management Practice, Inc.));
Remand Release, supra note 1, at note 69 (citing
Kathleen Pender, ‘‘SEC’s Fund Rule, Revisited,’’
San Francisco Chron., June 23, 2005, at C1 (quoting
fund governance analyst Meyrick Payne as
estimating ‘‘that the industry-wide cost of having
independent chairs, ‘at an absolute maximum, is
$18 million’ a year, which is ‘a drop in the bucket’
for an industry with $8 trillion in assets.’’)). Before
relying so heavily on the data from Management
Practice Inc., the majority should have analyzed
whether the data are robust and representative.
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public record. In any case, before
relying so heavily on this summary, the
majority should have included this
summary in the comment file to alert
the public of its intention to rely upon
it. The public then could have reacted
to it. The Commission’s economists
should have evaluated the underlying
data. The information presented in the
summary may inform any decision that
we make,27 but it should not do so in
isolation. Others who are not
consultants to independent directors, as
the author of this summary is, might
have supplemented or contradicted the
data.28 Of course, this process could not
possibly have occurred within the eightday period the majority allowed itself.
Therefore, after having forced the
Commission to act within an impossibly
short timeframe, the majority cannot
claim to have not done the ‘‘best it can,’’
as the Court directed the Commission to
do.29
Disclosure Alternative
In addition to finding fault with the
Commission’s analysis of costs, the
Court took issue with our consideration
of alternatives. Specifically, the Court
stated that the Commission should have
considered the disclosure alternative
that Commissioner Glassman and I
suggested as an alternative to the
independent chairman requirement.30
The Commission’s failure to do so
violated the APA 31 because, as the
Court said, ‘‘the disclosure alternative
was neither frivolous nor out of
bounds.’’ 32 Accordingly, the Court
directed the Commission to ‘‘bring[] its
expertise and its best judgment to bear’’
to consider the disclosure alternative.33
Oddly, neither the majority nor the staff
solicited our views on the disclosure
27 As the Draft Release notes, Commissioner
Glassman and I cited an earlier version of the data
in our dissent. Remand Release, supra note 1, at
note 28 and Adoption Dissent, supra note 3, at note
24.
28 A recent e-mail from C. Meyrick Payne, a senior
partner at Management Practice Inc. (‘‘MPI’’), the
author of the summary, suggests that MPI might
have an interest in perpetuating this rulemaking.
See E-mail from C. Meyrick Payne to Various
Recipients (June 26, 2005) (attachment to Letter
from Cory J. Skolnick of Gibson, Dunn & Crutcher
LLP to Jonathan G. Katz, Secretary of the SEC (June
28, 2005) (in the email, Mr. Payne stated that, in
advance of the Commission’s open meeting, people
might want to express their support for the
independent chairman provision: ‘‘If you, or your
board, feel that an independent chair is an
appropriate response to the recent mutual fund
scandals you might like to write to SEC or your
favorite newspaper on Monday or Tuesday so that
your opinion can be influential.’’).
29 Slip Opinion, supra note 2, at 15.
30 Slip Opinion, supra note 2, at 17.
31 Slip Opinion, supra note 2, at 17.
32 Slip Opinion, supra note 2, at 18 (citation
omitted).
33 Slip Opinion, supra note 2, at 19.
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alternative before (or after) circulating a
draft that concluded that the disclosure
alternative was without merit. Thus, the
majority’s action cannot be said to
embody the expertise and best judgment
of the Commission.
The Remand Release largely reiterates
an argument, already dismissed by the
Court as unconvincing,34 namely that
the Investment Company Act always
favors a prescriptive approach over a
disclosure approach.35 As the court
explained, ‘‘that the Congress required
more than disclosure with respect to
some matters governed by the ICA does
not mean it deemed disclosure
insufficient with respect to all such
matters.’’ 36 The release ignores that we
have found disclosure rather than
presciptive, one-size-fits-all solutions to
be sufficient in other contexts.37
The majority claims that the
proposing release elicited comment on
the disclosure alternative. Although the
proposing release did ask whether the
Commission should consider any
alternatives to the proposal, disclosure
was not specifically mentioned.38 As the
majority notes, a few commenters 39sua
sponte raised the possibility of allowing
investors to choose among funds based
on clear disclosure about the
independence of their chairman.40
These comments were ignored and the
staff’s summary of comments, which
was provided to the Commission prior
to adoption, did not discuss them.
Commissioner Glassman’s and my
attempts to find a disclosure-based
compromise were also ignored. In light
of the failure of the majority to consider
the disclosure alternative prior to
34 Slip
Opinion, supra note 2, at 18.
Release, supra note 1, at text
accompanying notes 76–82.
36 Slip Opinion, supra note 2, at 18.
37 See, e.g., Disclosure Regarding Approval of
Investment Advisory Contracts by Directors of
Investment Companies, Investment Company Act
Release No. 26486 (June 23, 2004) [69 FR 39798
(June 30, 2004)] (requiring investment companies to
provide disclosure to shareholders regarding
determinations that formed the basis for the board’s
approval of advisory contracts).
38 See also Staff Report, supra note 15, at 59–60
(a section entitled ‘‘Alternatives Were Considered’’
makes no mention of disclosure as an alternative).
39 See Comment Letter of the Financial Services
Roundtable, File No. S7–03–04 (Mar. 10, 2004)
(‘‘[I]nvestors will be able to express their views on
this [independent chairman] issue, given clear and
appropriate disclosure. * * * Investors for whom
this issue is a priority can direct their investments
to those funds.’’); Comment Letter of Charles K.
Carlson, President, Greenspring Fund Incorporated,
File No. S7–03–04 (June 17, 2004) (‘‘Greater
disclosure of relevant information would allow
shareholders to make better informed decisions. If
an independent Chairman is desirable in the eyes
of some investors, then make that information
readily accessible.’’).
40 Remand Release, supra note 1, at note 10 and
accompanying text.
35 Remand
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adoption, it is hard to understand how
the pre-adoption rulemaking record can
now be relied upon to form the basis for
a full and fair discussion of this
alternative.
Plea for a Deliberative Approach
Commissioner Glassman and I have
both called for a more deliberate
response to the Court. We could, for
example, conduct a formal, unbiased
survey, host a roundtable, or solicit
additional public comment on the
issues raised by the Court. Many others
have made similar pleas for a more
deliberate approach than that pursued
by the majority.41 Because the failures
identified by the Court relate to issues
that were not fully aired during the
notice-and-comment process, one
logical approach would seem to be to do
so now. As the Court explained,
‘‘uncertainty may limit what the
Commission can do, but it does not
excuse the Commission from its
statutory obligation to do what it can to
apprise itself—and hence the public and
the Congress—of the economic
consequences of a proposed regulation
before it decides whether to adopt the
measure.’’ 42
41 See, e.g., ICI Letter, supra note 23, at 1 (‘‘In
light of the court’s decision, we recommend that the
Commission invite additional public comment and
collect additional data to assure a thoughtful and
deliberative process.’’); Letter from Eight Senators
to Commission (June 22, 2005), at 1 (‘‘[W]e are
asking that the Commission defer final action on
this controversial and complex matter until the
Commission’s new chairman is in office and the full
Commission can make a deliberate decision.’’);
Letter from Joseph A. Grundfest, W.A. Franke
Professor of Law and Business, Stanford Law
School, to Commission (June 23, 2005), at 3 (‘‘The
inescapable concern is that this sequence of events
supports the inference that the matter has been
prejudged and that any additional consideration of
the record is being conducted more as a procedural
fig leaf than as a professional and good faith
inquiry.’’); Letter from Bevis Longstreth to the
Commission (June 24, 2005) (‘‘Input on these issues
from both the industry and its client base must be
obtained, and this evidence-gathering cannot be
done in a week’s time.’’); Letter from Harvey L. Pitt,
Kalorama Partners LLC, to Commission (June 23,
2005) (writing, as one of the seven ‘‘living former
SEC Chairmen’’ who supported the rulemaking
prior to adoption, to recommend a more
deliberative approach); Letter from Eugene Scalia,
Gibson, Dunn & Crutcher LLP, to Giovanni P.
Prezioso, General Counsel, SEC (June 23, 2005)
(writing on behalf of the Chamber of Commerce to
urge the Commission to ‘‘engage in a thorough,
rigorous, and deliberate process’’); Letter from
Walter B. Stahr to Commission (June 24, 2005), at
1 (urging the Commission to reconsider its plan ‘‘to
re-issue the same rules, presumably on the basis of
a quick analysis of the costs and alternatives’’);
Letter from Richard M. Whiting, Executive Director
and General Counsel, The Financial Services
Roundtable, to Jonathan Katz, Secretary, SEC (June
27, 2005), at 1 (requesting that ‘‘no final action on
the Rule be taken prior to the conclusion of [a] new
public comment and fact-finding process’’).
42 Slip Opinion, supra note 2, at 17 (emphasis
added).
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In the Remand Release, the majority
boldly states that taking more than eight
days to reflect on this issue ‘‘risks
significant harm to investors.’’ 43 The
majority does not elaborate on how
delaying action on the remand for the
short time that it would take to do a
thorough study would endanger
investors.44 When circumstances have
required it, the Commission has delayed
other actions that it has deemed to be of
great importance to investors.45 The
urgency of forcing funds to change their
governance structures seems to be more
closely tied to the imminent departures
of Chairman William Donaldson 46 and
Commissioner Harvey Goldschmid 47
than to legitimate concerns about the
well-being of the shareholders in the
many fund groups that do not have
independent chairmen.
The Remand Release admits that the
timing of this action is personneldriven. It explains that the Commission
needs to act expeditiously to marshal
‘‘the collective judgment and learning’’
of the five commissioners that originally
considered the rule.48 It does not note
the significant procedural and
substantive objections that
Commissioner Glassman and I raised
before the rule was originally adopted.
It does not note our futile pleas that the
Commission obtain more empirical
43 Remand Release, supra note 1, at text following
note 11.
44 The majority’s claimed interest in certainty for
funds rings hollow because, by taking this hasty
action, they have virtually ensured further litigation
over this matter. See Remand Release, supra note
1, at note 15 (‘‘Even prior to our having issued this
Release, there have been reports that additional
legal proceedings may result from our action today.
Accordingly, we are instructing our Office of the
General Counsel to take such action as it considers
appropriate to respond to any proceedings relating
to this rulemaking’’).
45 See, e.g., Amendment to Rule 4–01(a) of
Regulation S–X Regarding the Compliance Date for
Statement of Financial Accounting Standards No.
123 (Revised 2004), Share-Based Payment,
Securities Act Release No. 8568 (Apr. 15, 2005) [70
FR 20717 (Apr. 21, 2005)] (allowing companies to
delay implementation of accounting standard
governing employee stock options); Management’s
Report on Internal Control over Financial Reporting
and Certification of Disclosure in Exchange Act
Periodic Reports of Non-Accelerated Filers and
Foreign Private Issuers; Extension of Compliance
Dates, Securities Act Release 8545 (Mar. 11, 2005)
[70 FR 13328 (Mar. 18, 2005)] (extending a rule
implementing Section 404 of the Sarbanes-Oxley
Act, which was a direct statutory mandate).
46 SEC Chairman William H. Donaldson to Step
Down on June 30, SEC Press Release 2005–82 (June
1, 2005) (https://www.sec.gov/news/press/2005–
82.htm).
47 Robert Schmidt and Otis Bilodeau, SEC’s
Nazareth is Democrats’ Choice for Commissioner,
BLOOMBERG (May 18, 2005) (reporting
‘‘Goldschmid’s plan to retire from the SEC by
August and return to teach at Columbia’s law
school’’).
48 Remand Release, supra note 1, at text preceding
note 14.
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evidence. More importantly, though, if
the Commission adopts a meritorious
rule under lawful procedures, then the
composition of the Commission that
adopted it is irrelevant. The rule should
be able to weather the inevitable
personnel changes at the Commission
and stand on its own without the
support of the three commissioners that
originally voted for it.
Lastly, I question the majority’s
conclusion that ‘‘[t]he Court did not
vacate the rule amendments * * * and
VerDate jul<14>2003
19:50 Jul 06, 2005
Jkt 205001
they remain in effect.’’ 49 The Court
specifically identified two statutory
violations in the process by which the
majority adopted these rules. Until these
statutory violations are remedied, the
rule is not in effect, because the
Commission has not satisfied the
statutory predicate for legitimacy and
enforceability of our rules. The only
way for us to cure these fatal flaws is to
49 Remand Release, supra note 1, at text preceding
Section II (‘‘Introduction’’).
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39409
comply with the Administrative
Procedure Act and the Investment
Company Act as the Court has directed
us to do and which today’s action does
not do.
The Court gave the Commission a
chance to redeem itself. It told us what
we needed to do to fulfill our legal
obligation. Unfortunately, the majority
has squandered this opportunity. For
the reasons stated above, I dissent.
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ER07JY05.031
[FR Doc. 05–13314 Filed 7–6–05; 8:45 am]
Agencies
[Federal Register Volume 70, Number 129 (Thursday, July 7, 2005)]
[Rules and Regulations]
[Pages 39390-39410]
From the Federal Register Online via the Government Printing Office [www.gpo.gov]
[FR Doc No: 05-13314]
[[Page 39389]]
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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. 70, No. 129 / Thursday, July 7, 2005 / Rules
and Regulations
[[Page 39390]]
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SECURITIES AND EXCHANGE COMMISSION
17 CFR Part 270
[Release No. IC-26985; File No. S7-03-04]
RIN 3235-AJ05
Investment Company Governance
AGENCY: Securities and Exchange Commission.
ACTION: Commission response to remand by court of appeals.
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SUMMARY: The Commission has considered further its adoption of
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 reconsideration responds to
a decision by the United States Court of Appeals for the District of
Columbia Circuit remanding to us for further consideration two issues
raised by the rulemaking.
FOR FURTHER INFORMATION CONTACT: Penelope Saltzman, Branch Chief, or C.
Hunter Jones, Assistant Director, Office of Regulatory Policy, (202)
551-6792, Division of Investment Management, Securities and Exchange
Commission, 100 F Street, NE., Washington, DC 20549.
SUPPLEMENTARY INFORMATION: In Chamber of Commerce of the United States
of America v. Securities and Exchange Commission, the United States
Court of Appeals for the District of Columbia Circuit remanded to us,
in part, for additional consideration certain amendments we adopted
last year to ten rules under the Investment Company Act of 1940
(``Investment Company Act'' or ``Act'').\1\ The amendments are
applicable to funds that rely on any of ten exemptive rules the
Commission has adopted under the Investment Company Act (``Exemptive
Rules'').\2\ The amendments were 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. As
the Court directed, the Commission has carefully considered the issues
identified by the Court in remanding this matter to us. We have
determined, in light of that consideration, that the amendments to the
Exemptive Rules require no modification.
---------------------------------------------------------------------------
\1\ Chamber of Commerce of the United States of America v. SEC,
No. 04-1300, slip op. (D.C. Cir. June 21, 2005) (``Slip Opinion'').
\2\ Investment Company Governance, Investment Company Act
Release No. 26520 (July 27, 2004) [69 FR 46378 (Aug. 2, 2004)]
(``Adopting Release''). The Exemptive Rules are listed in the
Adopting Release at footnote 9.
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I. Background
On July 27, 2004, the Commission adopted amendments to the
Exemptive Rules under the Investment Company Act to require funds that
rely on one or more of those rules to adopt certain governance
practices.\3\ Among other things, the amendments added two conditions
for relying on the Exemptive Rules. The amendments require that, if a
fund relies on at least one of the Exemptive Rules to engage in certain
transactions otherwise prohibited by the Act, the fund must have a
board of directors with (i) no less than 75 percent independent
directors,\4\ and (ii) a chairman who is an independent director. We
adopted the amendments in the wake of a troubling series of enforcement
actions involving late trading, inappropriate market timing activities,
and misuse of nonpublic information about fund portfolios.\5\
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\3\ Adopting Release, supra note 2.
\4\ 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 section 2(a)(19) of the Act [15 U.S.C.
80a-2(a)(19)].
\5\ See Adopting Release, supra note 2, at nn.5-6 and
accompanying text.
---------------------------------------------------------------------------
The two new conditions were challenged by the Chamber of Commerce,
which submitted a petition for review to the United States Court of
Appeals for the District of Columbia Circuit. In that case, the Chamber
of Commerce asserted that the Commission (i) lacked authority to adopt
the amendments, and (ii) violated the Administrative Procedure Act
(``APA'').\6\
---------------------------------------------------------------------------
\6\ 5 U.S.C. 551 et seq.
---------------------------------------------------------------------------
On June 21, 2005, the Court of Appeals issued its decision that
``the Commission did not exceed its statutory authority in adopting the
two conditions, and the Commission's rationales for the two conditions
satisfy the APA.'' \7\ The Court noted the broad authority granted to
the Commission to exempt transactions ``subject only to the public
interest and the purposes of the [Act].'' \8\ In addition, the Court
found that our actions were reasonable in light of the significant
problems we identified with mutual funds that have arisen as a result
of serious conflicts of interest.
---------------------------------------------------------------------------
\7\ Slip Opinion, supra note 1, at 2.
\8\ Id. at 7.
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The Court, however, remanded to the Commission for our
consideration two deficiencies that it identified in the rulemaking.
First, the Court held that, in connection with our statutory obligation
to consider whether the conditions will promote efficiency, competition
and capital formation, we did not adequately consider costs associated
with the 75 percent independent board and the independent chairman
conditions. Second, the Court stated that we did not give adequate
consideration to an alternative discussed by the two Commissioners who
dissented from the adoption of the rules (``disclosure alternative'').
The Court did not vacate the rule amendments, however, and they remain
in effect.\9\
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\9\ See id. at 19 (ordering the matter ``remanded'' and citing
Fox Television Stations, Inc. v. FCC, 280 F.3d 1027, 1048-49 (D.C.
Cir. 2002) (explaining reasons for remanding a rulemaking without
vacating) and Allied Signal, Inc. v. U.S. Nuclear Regulatory Comm'n,
988 F.2d 146, 150-51 (D.C. Cir. 1993) (same)).
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II. Introduction
In this Release, we further consider and address the two issues
raised by the Court's remand order. As a threshold matter, we consider
whether it is necessary to engage in additional fact-gathering to
implement the Court's remand order, or otherwise engage in further
notice and comment procedures.\10\ The existing record, which was
before the Commission at the time the amendments were adopted, was
developed through full notice and comment procedures. The notice
initiating those procedures and soliciting public comment proposed two
conditions for exemption that were substantially identical to the
conditions that we adopted and that are supported by our additional
discussion in this Release. Although the Court held that we ultimately
failed in our Adopting Release adequately to address the issues
identified by the Court in its opinion, we had specifically sought and
received comment on the costs associated with the two conditions and
had considered those costs at the time of the initial rulemaking. We
further note that the original notice solicited comment on
[[Page 39391]]
whether there were alternatives that would serve the same or similar
purposes, and elicited comment on the disclosure alternative.\11\ We
find that the information in the existing record, together with
publicly available information upon which we may rely, is a sufficient
base on which to rest the Commission's consideration of the
deficiencies identified by the Court. Thus, our consideration and
discussion in this Release of the two issues relies upon that record
and previously available public information, and we have determined
that it is not necessary to engage in further notice and comment
procedures in order to follow the Court's direction on remand.
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\10\ Where, as here, a court does not specify a required
procedure, the agency is free on remand to determine whether
supplemental fact-gathering is necessary. Furthermore, if the
existing record is a sufficient base on which to address on remand
the court-identified deficiencies, additional notice and comment
procedures are not required. See Sierra Club v. EPA, 325 F.3d 374,
382 (D.C. Cir. 2003) (following the ``usual rule'' by remanding
``for further explanation, though not necessarily for further
notice-and-comment rulemaking''); National Grain and Feed Ass'n,
Inc. v. OSHA, 903 F.2d 308, 310-11 (5th Cir. 1990) (leaving ``the
agency free on remand to determine whether supplemental fact-
gathering is necessary for correction of the perceived error or
deficiency.''). See also AT&T Wireless Servs., Inc. v. FCC, 365 F.3d
1095, 1103 (D.C. Cir. 2004) (upholding after remand additional
explanation of prior FCC decision where FCC found on remand that
``the existing record was `a sufficiently adequate base on which to
rest the Commission's decision * * *'').
\11\ See Investment Company Governance, Investment Company Act
Release No. 26323 (Jan. 15, 2004) [69 FR 3472 (Jan. 23, 2004)]
(``Proposing Release''), at text preceding n.32; see also Comment
Letter of the Financial Services Roundtable, File No. S7-03-04 (Mar.
10, 2004) (``[I]nvestors will be able to express their views on this
[independent chairman] issue, given clear and appropriate
disclosure. * * * Investors for whom this issue is a priority can
direct their investments to those funds.''); Comment Letter of
Greenspring Fund, Incorporated, File No. S7-03-04 (June 17, 2004)
(``Greater disclosure of relevant information would allow
shareholders to make better informed decisions. If an independent
Chairman is desirable in the eyes of some investors, then make that
information readily accessible.'').
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Moreover, engaging in further notice and comment procedures is not
only unnecessary, it risks significant harm to investors without
significant corresponding benefits, given the adequacy of the
information currently available upon which we may rely. The amendments
to the Exemptive Rules are the centerpiece of a broader regulatory
effort to restore investor confidence in the mutual fund industry in
the wake of the discovery of serious wrongdoing at many of the nation's
largest fund complexes and by officials at the highest levels of those
complexes. Fund managers acted in their own interests rather than in
the interests of fund investors (which they are required to do),
resulting in substantial investor losses that were well documented at
the time we adopted the amendments. Further, subsequent events,
although they do not form the basis of our action, have shown that the
level of wrongdoing, and the corresponding investor losses, were in
fact significantly greater than was known at that time. By acting
promptly, we hope to bolster investor confidence, resolve any
uncertainties associated with the remand, and ensure that investors
receive the protections afforded by the amendments without delay.\12\
It is important that we avoid postponement of the compliance date and
the attendant potential harm to investors and the market that would
result.\13\
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\12\ As noted above, the Court, while remanding a portion of the
rulemaking for our consideration, did not vacate the rule
amendments. See Slip Opinion, supra note 1, at 19.
\13\ See Adopting Release, supra note 2, at Section IV (funds
relying on Exemptive Rules must begin complying with the Exemptive
Rule amendments after January 15, 2006).
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Because Chairman Donaldson was scheduled to leave the Commission on
June 30, 2005, and his replacement, although announced by the
President, had not been formally nominated by him or confirmed by the
Senate, we considered it important to act on this important matter no
later than the time of our open meeting scheduled for June 29, 2005. In
adopting the amendments to the Exemptive Rules, we carefully considered
the issues presented by the rulemaking and reviewed the extensive
record before the Commission. This is the last opportunity to bring the
collective judgment and learning of all of us, who have spent the last
year and a half thinking about the issues raised in this rulemaking, to
bear on the important questions presented to us by the Court. Given our
unique familiarity with these matters, we think it is both important
and appropriate for the same five of us to consider the issues raised
by the Court on remand, especially given the potential harm that may
result from delay in resolving this matter.
We take very seriously and act with the utmost respect for the
Court of Appeals' admonition that we failed adequately to consider the
costs imposed upon funds by the two challenged conditions, and failed
to consider the disclosure alternative. Our determination to act
promptly in no way diminishes our obligation to make a deliberate and
careful consideration of the issues raised by the Court. We have
undertaken to address those issues upon remand promptly because we are
convinced that we can do so with the thoroughness and careful
consideration required by the Court's direction to us, and without the
sacrifice to investor protection that delay would risk. Because we have
previously sought and received comment, the Commission has a
significant foundation from which to consider the issues remanded by
the Court. In light of that experience, and because the existing record
and other publicly available information allow us to undertake the
additional consideration required, we have determined that we can fully
discharge our responsibilities within the time necessary to allow
participation by the same group of Commissioners that adopted the
amendments to the Exemptive Rules. Our failure to act at this time,
moreover, risks the creation of significant uncertainties and potential
harm to investors that would not, in our judgment, be in the public
interest.\14\
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\14\ Even prior to our having issued this Release, there have
been reports that additional legal proceedings may result from our
action today. Accordingly, we are instructing our Office of the
General Counsel to take such action as it considers appropriate to
respond to any proceedings relating to this rulemaking.
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III. Discussion
A. Costs Resulting From Exemptive Rule Amendments
In the release proposing the amendments to the Exemptive Rules, we
discussed and solicited comment on the costs and benefits of those rule
amendments, and whether they would promote efficiency, competition and
capital formation.\15\ In the Adopting Release, we again discussed the
costs and benefits of the amendments, and whether they would promote
efficiency, competition and capital formation.\16\
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\15\ Proposing Release, supra note 11, at Sections V and VII.
\16\ Adopting Release, supra note 2, at Sections VI and VIII. As
the Court noted, section 2(c) of the Investment Company Act [15
U.S.C. 80a-2(c)] 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. Slip Opinion, supra note 1, at 12-13.
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In this Release, we reexamine the costs of the Exemptive Rule
amendments in the two areas identified by the Court: (i) The costs to
funds of complying with the condition that at least 75 percent of a
fund's directors be independent; and (ii) the costs to funds of
complying with the condition that the chairman be an independent
director, particularly the costs of possible additional staff that the
independent chairman might hire.\17\
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\17\ In preparing estimates in this Release, we rely where
appropriate on data that can be obtained or confirmed through
publicly available filings under the Federal securities laws.
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1. Board Composition
The amendments will impose additional costs on funds that rely on
any of the Exemptive Rules by requiring that independent directors
constitute at least 75 percent of the fund board or, if the fund board
has only three directors, that all but one director be independent. As
discussed in the Adopting Release, we have estimated that nearly 60
percent of all funds currently meet the 75 percent condition.\18\ A
fund that does not already meet this condition may come into compliance
with the 75 percent condition by: (i) Decreasing the size of its board
and allowing some
[[Page 39392]]
interested directors to resign; (ii) appointing new independent
directors either to replace interested directors (maintaining the
current size of its board) or to increase the current size of its
board; \19\ or (iii) electing new independent directors either to
replace interested directors (maintaining the current size of its
board) or to increase the current size of its board.\20\ In order to
provide funds with maximum flexibility, we did not specify which option
they must select.
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\18\ See Adopting Release, supra note 2, at n.78.
\19\ 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)] (board vacancy may be
filled by any legal manner if immediately after filling the vacancy
at least two-thirds of directors have been elected by fund
shareholders).
\20\ Our description of the three options available to funds
differs slightly from the description in the Adopting Release. As
discussed in greater detail below, funds will incur costs to add new
independent directors regardless of whether those new independent
directors replace interested directors or increase the size of the
board. Funds' costs will differ, however, depending on whether the
board can appoint the new independent directors under section 16(a)
of the Act or whether the fund's shareholders must approve the new
independent directors. Unlike funds whose boards can appoint new
independent directors, funds that must obtain shareholder approval
for new independent directors will incur proxy solicitation
expenses.
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In the Adopting Release, we stated that ``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.'' \21\ The Court of
Appeals noted, however, that ``[t]hat particular difficulty may mean
the Commission can determine only the range within which a fund's cost
of compliance will fall,'' \22\ and directed that the Commission
determine as best it can the economic implications of the rule. Based
on the record in this matter, as well as our review of publicly
available information, we have concluded that we do in fact have a
reliable basis upon which to consider the range of costs associated
with each of the different ways in which funds may choose to comply
with the 75 percent condition, as the Court directed.
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\21\ See Adopting Release, supra note 2, at text accompanying
n.80.
\22\ Slip Opinion, supra note 1, at 15-16 (``That particular
difficulty [of determining aggregate costs] may mean the Commission
can determine only the range within which a fund's cost of
compliance will fall, depending upon how it responds to the
condition * * .'').
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a. Adding Independent Directors
Funds that elect to add independent directors in order to meet the
75 percent condition have two options. They may replace some interested
directors with independent directors, or they may increase the size of
the board. Funds that choose simply to replace interested directors
with independent directors or that add additional independent directors
and are able to appoint the new independent directors may incur three
kinds of costs. First, funds may incur initial and periodic costs of
finding qualified candidates. Second, funds will incur annual
compensation costs for the new independent directors. Third, funds
could incur additional annual costs if new independent directors use
additional services of independent legal counsel.\23\ Because smaller
fund groups typically provide less compensation (for overseeing fewer
funds) than larger fund groups (for overseeing more funds), our
compensation estimates are based on a range of potential costs.
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\23\ We also considered whether funds might incur additional
costs as a result of additional premiums for directors' liability
insurance. Most policies covering mutual fund directors' liability
are priced based principally on the level of risk estimated by the
insurer, on the amount of assets under management, and on the
maximum aggregate limit of liability covered, rather than on the
number of directors. Given our expectation that implementation of
the rule amendments, with their effect of strengthening independent
oversight of conflicts of interest, will reduce the risk of
misconduct and ensuing investor losses, the cost of insuring against
such risk should, if anything, be reduced. In any event, we have
concluded that an increased cost of coverage associated with the two
conditions, if any, will be minimal and will be adequately covered
by the allowances for overhead and the cushions we have used in
considering costs.
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We understand that a majority of funds have eight or fewer
directors.\24\ Accordingly, we conclude that most funds could appoint
one or two independent directors in order to comply with the 75 percent
condition.\25\ For example, a board with eight directors could comply
with the condition by replacing one interested director with an
independent director.\26\ However, we received one comment from a fund
with five directors that stated it would not want to reduce the number
of interested directors, and therefore would have to add three new
independent directors in order to meet the 75 percent condition.\27\ In
light of this comment, and acting conservatively so as not to
underestimate costs, we have estimated for purposes of this discussion
that a fund would appoint three new independent directors.
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\24\ See Management Practice Inc. Bulletin: Fund Directors' Pay
Increases 17% in Smaller Complexes, 8% in Larger (June 2003)
(``Boards are getting smaller with 60% having 8 directors or
less.'') (available at: https://www.mfgovern.com/); Management
Practice Inc. Bulletin: More Meetings Means More Pay for Fund
Directors (Apr. 2004) (``April 2004 MPI Bulletin'') (``Boards are
staying about the same overall size, with a slight decrease in the
number of interested directors, which facilitates a new 75%
independent requirement.'').
\25\ A fund that currently relies on any of the Exemptive Rules
would already have a majority of independent directors on the board.
See Role of Independent Directors of Investment Companies,
Investment Company Act Release No. 24816 (Jan. 2, 2001) [66 FR 3734
(Jan. 16, 2001)].
\26\ An 8 member board of a fund that relies on at least one
Exemptive Rule currently must have at least 5 independent directors.
By replacing an interested director with an independent director, 6
out of 8 (75%) would be independent. By replacing two interested
directors with two independent directors on a 7 member board (which
must have at least 4 independent directors), 6 out of 7 (86%) would
be independent.
\27\ See Comment Letter of the Disinterested Directors of ICAP
Funds, Inc., File No. S7-03-04 (Mar. 4, 2004).
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Based on data from a 2004 survey of mutual fund directors'
compensation,\28\ we estimate that the median annual salary for
directors ranges from $111,500 (for boards that oversee a large number
of funds \29\) down to $12,500 (for boards that oversee from 1 to 6
funds). Consistent with the approach suggested by the Court with
respect to the hiring of additional staff in connection with the
independent chairman condition, we make the estimates based upon the
potential costs to an individual fund. Thus, we estimate the annual
compensation cost per fund for appointing one independent director
could range from $1593 (for boards that oversee a large number of
funds) to $12,500 (for boards that oversee only one fund).\30\
Accordingly, if a fund were to appoint three independent directors, we
[[Page 39393]]
estimate that these annual compensation costs could range, on a per
fund basis, from $4779 (for boards that oversee a large number of
funds) to $37,500 (for boards that oversee one fund).\31\
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\28\ See April 2004 MPI Bulletin, supra note 24. The information
provided in the Bulletin ``summarizes 2003/4 findings of the Mutual
Fund Directors'' Compensation and Governance Practices survey with
data drawn from public documents of 290 complexes, representing
1,620 directors/trustees and the confidential responses of
participating complexes.'' Thus, the survey may include compensation
information concerning both independent and interested directors.
Because interested directors generally are compensated by the
adviser, not the fund, we have assumed for purposes of the estimates
that the compensation reflects annual compensation of independent
directors. This survey is a widely used industry survey, an earlier
version of which was cited by the dissenting Commissioners in their
statement attached to the Adopting Release. See Adopting Release,
supra note 2, Dissent of Commissioners Cynthia A. Glassman and Paul
S. Atkins, at n.24.
\29\ For purposes of these estimates, we define boards that
oversee a ``large number'' of funds as boards that oversee 70 or
more funds. The per fund estimates we discuss related to these
boards are calculated by basing per fund costs on a board that
oversees 70 funds, which yields greater per fund costs than using a
higher number would.
\30\ These annual estimates of the cost of one independent
director are based on the following calculations: ($111,500 / 70
funds = $1593); ($12,500 / 1 fund = $12,500). In considering the
range of costs per fund, we divided the median salary for a director
overseeing a large number of funds (70 or more) by 70 funds, and the
median salary for a director overseeing a small number of funds (1
to 6) by 1 fund. The range of funds was based on data provided in
the April 2004 MPI Bulletin, supra note 24.
\31\ These annual estimates of the cost per fund are based on
the following calculations: ($1593 x 3 directors = $4779); ($12,500
x 3 directors = $37,500).
We note that commenters' estimated costs of paying new
independent directors ranged from $4000 to $20,000, which are
roughly comparable with and do not exceed our estimated range. See
Comment Letter of New Alternatives Fund, Inc., File No. S7-03-04
(Feb. 9, 2004); Comment Letter of Independent Directors of Flaherty
& Crumrine Preferred Income Opportunity Fund Inc., File No. S7-03-04
(Feb. 23, 2004).
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We further estimate that the costs to recruit an independent
director may equal the independent director's first year salary.\32\
This cost may be incurred initially when the independent directors are
first appointed, and periodically thereafter when, from time to time,
an independent director is replaced. In our judgment, we conservatively
estimate that the need to replace a director will, on average, occur no
more often than once every five years.\33\ Thus, the initial per fund
cost for recruiting services for three independent directors could
range from $4779 (for boards that oversee a large number of funds) to
$37,500 (for boards that oversee one fund).\34\ Based on turnover every
five years, the annual cost per fund thereafter to replace independent
directors could range from $956 to $7500.\35\
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\32\ See, e.g., Andrea Felsted, Headhunters Feel the Heat in
Quality Quest: Shareholder Reaction to Sainsbury's Choice of a
Chairman-Designate has Shed a Harsh Light on a Secretive World,
FINANCIAL TIMES, Feb. 21, 2004, at 5. This one-time cost would be
shared among the funds that the director oversees.
\33\ See, e.g., Management Practice Inc. Bulletin: Mutual Fund
Directors' Compensation Increases 9% in a Turbulent Year (last
modified Oct. 30, 2001) (available at https://www.mfgovern.com/)
(noting that, based on a 2000 survey, ``[s]erving trustees have a
median age of 62 with a median of 10 years of service.'').
\34\ See supra note 31.
\35\ These estimates are based on the following calculations:
($4779 / 5 = $956); ($37,500 / 5 = $7500).
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We expect that funds will incur additional costs because of
increased reliance by new independent directors on the services of
independent legal counsel. Based upon our experience, we estimate that,
on average, the new independent directors will use an additional 30
hours annually of independent legal counsel services. We have estimated
that the average hourly rate for an independent counsel is $300,\36\
which yields a total cost of $9000 annually, per board. Thus, the range
of costs for additional independent counsel services could range from
$9000 per fund (for a board that oversees one fund) to $129 per fund
(for a board that oversees a large number of funds).\37\
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\36\ The $300 per hour estimated billing rate is one we have
used in recent rulemakings. See, e.g., Disclosure Regarding
Nominating Committee Functions and Communications Between Security
Holders and Boards of Directors, Securities Act Release No. 8340
(Nov. 24, 2003) [68 FR 69204 (Dec. 11, 2003)] at n.149.
\37\ These estimates are based on the following calculations:
($9000 / 1 = $9000); ($9000 / 70 = $129).
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Estimated total costs per fund. Based on this data, we estimate
that the total costs in the first year, for funds that appoint three
new independent directors, could range from $9687 per fund (for boards
that oversee a large number of funds) to $84,000 per fund (for boards
that oversee one fund).\38\ Annual costs in subsequent years would
decrease to a range of $5864 per fund (for boards that oversee a large
number of funds) to $54,000 per fund (for boards that oversee only one
fund).\39\
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\38\ These estimates are based on the following calculations:
($4779 (first year compensation) + $4779 (recruiting costs) + $129
(independent counsel costs) = $9687); ($37,500 (first year
compensation) + $37,500 (recruiting costs) + $9000 (independent
counsel costs) = $84,000).
\39\ These estimates are based on the following calculations:
($4779 (annual compensation) + $956 (recruiting costs) + $129
(independent counsel costs) = $5864); ($37,500 (annual compensation)
+ $7500 (recruiting costs) + $9000 (independent counsel costs) =
$54,000).
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Funds that must obtain shareholder approval for new independent
directors (whether to replace interested directors or to increase the
size of the board) will incur additional costs of soliciting proxies
from shareholders. We estimate the average costs of soliciting proxies
as $75,000 per fund.\40\ If a fund must obtain shareholder approval for
three new independent directors, the initial costs to add the directors
could range from $84,687 per fund (for boards that oversee a large
number of funds) to $159,000 per fund (for boards that oversee one
fund).\41\ And as discussed above, costs would decrease in subsequent
years to a range of $5864 per fund (for boards that oversee a large
number of funds) to $54,000 per fund (for boards that oversee only one
fund).\42\
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\40\ See Investment Company Mergers, Investment Company Act
Release No. 25666 (July 18, 2002) [67 FR 48512 (July 24, 2002)], at
Section V. That cost could be substantially diminished if a proxy
vote were scheduled to be held during the period on other matters.
\41\ These estimates are based on the following calculations:
($9687 (first year compensation, recruiting and independent legal
counsel costs) + $75,000 (proxy costs) = $84,687); ($84,000 (first
year compensation, recruiting and independent legal counsel costs) +
$75,000 (proxy costs) = $159,000).
\42\ See supra note 39.
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We have also estimated increased costs to funds to reflect the
increased responsibilities that independent directors may take on as a
result of the 75 percent condition. To reflect this and other possible
cost increases (including proxy cost increases), we have estimated that
costs of complying with the condition may today have increased by as
much as 20 percent.\43\ Accordingly, we have estimated current first
year costs of the condition for funds in which the board appoints three
new independent directors. These costs could range from $11,624 per
fund (for boards that oversee a large number of funds) to $100,800 per
fund (for boards that oversee one fund).\44\ We have further estimated
that the current first year cost for funds that elect three new
independent directors could range from $101,624 per fund (for boards
that oversee a large number of funds) to $190,800 per fund (for boards
that oversee one fund).\45\ Whether the new independent directors are
appointed or elected, ongoing costs could range from $7037 per fund
(for boards that oversee a large number of funds) to $64,800 per fund
(for boards that oversee one fund).\46\
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\43\ As to director compensation, the conservative nature of
this estimate is confirmed by publicly available information
indicating that in 2004, directors' compensation increased by 13
percent. See Management Practice Inc. Bulletin: More Meetings, More
Pay: Fund Directors' Compensation Increases 13% as Workload Grows
(Apr. 2005) (available at https://www.mfgovern.com).
\44\ These estimates are based on the following calculations:
($9687 x 1.2 = $11,624); ($84,000 x 1.2 = $100,800).
\45\ These estimates are based on the following calculations:
($84,687 x 1.2 = $101,624); ($159,000 x 1.2 = $190,800).
\46\ These estimates are based on the following calculations:
($5864 x 1.2 = $7037); ($54,000 x 1.2 = $64,800).
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b. Decreasing Interested Directors
Finally, funds that simply decrease the size of their boards and
allow some interested directors to resign are likely to incur, at most,
only minimal direct costs. The decision to reduce the size of the board
and eliminate one or more interested directors from the board would
likely be made at a previously scheduled board meeting.\47\ Because
this option is the simplest of the three options and imposes the lowest
direct costs, it is likely that many, if not most, funds will choose to
comply with the 75 percent condition by using this
[[Page 39394]]
option.\48\ There is the possible non-monetary cost of the loss of
experience on the board. In other words, having fewer interested
directors on the board might decrease the expertise of the board. As we
discussed in the Adopting Release, however, nothing in the Exemptive
Rule amendments would prohibit interested persons from participating in
board meetings, if the directors decide to include them in those
meetings.\49\ Thus we believe that the reduction in the number of
interested directors will likely result, at most, in only minimal
direct costs.\50\
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\47\ In the unusual circumstances in which the interested
directors are compensated by the fund rather than by the fund's
adviser, the termination of the interested directors could result in
a cost savings for the fund. We understand, however, that in most
cases the fund's adviser compensates the interested directors
directly.
\48\ See, e.g., April 2004 MPI Bulletin, supra note 24 (``Boards
stayed about the same size, but the number of affilaited directors
declined as the preferred method of achieving the required 75%
independent.''); Comment Letter of the Directors' Committee of the
Investment Company Institute, File No. S7-03-04 (Mar. 10, 2004)
(``While it is our expectation that most funds would reach this
percentage by asking an interested director to step down from the
board, there are some boards that will do so by adding an
independent director.''); Comment Letter of New Alternatives Fund,
Inc., File No. S7-03-04 (Feb. 9, 2004) (``[I]t is difficult to find
competent directors. An alternative is for the undersigned founder
to resign as a director while remaining a manager. We could then
reach the 75% requirement.'').
\49\ See Adopting Release, supra note 2, at text following n.50
and at text preceding and following n.60.
\50\ It would be impracticable to quantify the indirect costs of
choosing this option. Of course, if those indirect costs (plus the
insignificant direct costs) of this option were to exceed the total
direct and indirect costs associated with either of the other two
options, then the fund could choose to use one of those other,
lower-cost options.
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2. Independent Chairman
The Exemptive Rule amendments also require that a fund relying on
an Exemptive Rule have an independent director serve as chairman of the
board. As we noted in the Adopting Release, there may be costs
associated with the independent chairman condition, such as the costs
of hiring staff to assist the chairman in carrying out his or her
responsibilities.\51\ However, we said that we had no reliable basis
for estimating those costs. The Court of Appeals noted that
``[a]lthough the Commission may not have been able to estimate the
aggregate cost to the mutual fund industry of additional staff because
it did not know what percentage of funds with [an] independent chairman
would incur that cost, it readily could have estimated the cost to an
individual fund.'' \52\ Based on the record in this matter, as well as
a review of publicly available information, we have concluded that we
do in fact have a reliable basis for estimating the costs to an
individual fund associated with the independent chairman condition, as
the Court directed. This estimate also includes possible increased
compensation to independent chairs to reflect their additional
responsibilities.
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\51\ See Adopting Release, supra note 2, at n.81.
\52\ Slip Opinion, supra note 1, at 16-17.
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In addition to the monetary costs we discuss below, some have
raised, as a possible non-monetary cost, the loss of experience on the
board if the interested chairman were to resign from the board. The
interested chairman, however, typically is one of the most senior
officers of the fund's investment adviser, which has a direct interest
in the operations of the fund. Therefore, we anticipate that the
interested chairman is unlikely to resign from the fund's board, and
will likely continue to participate actively in board meetings even
though he no longer functions as the chairman.\53\
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\53\ Even in the unlikely case that the chairman resigns from
the board, we believe that the resignation would have minimal costs
because, as discussed above and in the Adopting Release, nothing in
the Exemptive Rule amendments would prohibit the former chairman
from participating in board meetings if the directors decide to
include him or her in those meetings. See supra note 49 and
accompanying text.
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A. Additional Staff
Several commenters suggested that an independent chairman might
decide to hire staff to help fulfill his or her responsibilities.\54\
Although we cannot determine how many independent chairmen would
require the hiring of additional staff to support them,\55\ we have
estimated the costs that fund boards may incur as a result of hiring
additional staff.\56\
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\54\ See, e.g., Comment Letter of Disinterested Trustees of EQ
Advisors Trust, File No. S7-03-04 (Mar. 4, 2004) (``[A] fund group
would need to compensate the [independent] chair commensurate with
his or her additional responsibility and time commitment and would
need to hire additional support for that individual.''); Comment
Letter of New Alternatives Fund, Inc., File No. S7-03-04 (Feb. 9,
2004) (estimating a $25,000 cost of ``aids to directors''); Comment
Letter of Sullivan & Cromwell LLP, File No. S7-03-04 (Mar. 9, 2004)
(``[W]e believe that mandating an independent chairman will
effectively mandate the retention of an independent staff and/or
enhanced participation by independent counsel in fund complexes both
large and small.''). The [chief compliance officer] and independent
counsel were viewed as the logical persons to interface regularly
with the Chair and their involvement may alleviate the need for
permanent staff to the board or Chair. The management company
typically provides the bulk of the secretarial and clerical support
for most boards.''). Despite the lack of consensus on whether an
independent chairman is likely to hire any additional staff, the
estimate discussed in this section--to avoid any underestimate of
costs--assumes the hiring of two additional staff members.
\55\ Adopting Release, supra note 2, at n.81.
\56\ These costs are for additional staff. An independent chair,
like a management affiliated chair, will continue to have available
the services of the existing staff of the fund management company.
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In our judgment, in most cases, independent chairmen will be
expected to hire no more than two staff employees, consisting of one
full-time senior business analyst and one full-time executive
assistant. We believe that these costs will be borne primarily by
larger fund complexes, and that independent chairmen at smaller
complexes will rarely choose to hire additional staff. We have
estimated the costs of retaining these personnel based on salary
surveys conducted by the Securities Industry Association (``SIA''), a
source on which we commonly rely in our rulemakings.\57\ The SIA found
the average salary (including bonus) of a senior business analyst to be
$136,671.\58\ Adjusting this salary upwards by 50 percent to reflect
possible overhead costs and employee benefits, this salary amounts to
$205,007. The SIA found the average salary of an executive assistant
(including bonus) to be $73,088.\59\ Adjusting this salary upwards by
50 percent to reflect possible overhead costs and employee benefits,
this salary amounts to $109,632. Thus, the hiring of both a full-time
senior business analyst and a full-time executive assistant for an
independent chairman would total approximately $314,639 for each board.
This cost can be expressed on a per fund basis, which we calculate to
be $42,519.\60\
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\57\ See, e.g., Disclosure Regarding Approval of Investment
Advisory Contracts by Directors of Investment Companies, Investment
Company Act Release No. 26486 (June 23, 2004) [69 FR 39798 (June 30,
2004)] at n.55.
\58\ See Securities Industry Association, REPORT ON MANAGEMENT &
PROFESSIONAL EARNINGS IN THE SECURITIES INDUSTRY (2004). This
estimate is for a New York salary. The SIA also estimates non-New
York salaries, which are lower. The estimates in this section use
the higher figure.
\59\ See Securities Industry Association, REPORT ON OFFICE
SALARIES IN THE SECURITIES INDUSTRY (2004).
\60\ This estimate is based on the following calculation:
($314,639 / 7.4 funds per board = $42,519 per fund). We estimate
that there are, on average, 7.4 funds per board. There were 8126
funds in 2003. See Investment Company Institute, 2004 MUTUAL FUND
FACT BOOK (May 2004). We estimate that there are approximately two
boards of directors per fund complex. We also estimate that in 2003
there were 550 fund complexes, yielding a total of 1100 fund boards.
Therefore, there are approximately 7.4 funds per board (8126 funds /
1100 boards).
This estimate exceeds an estimate provided by a commenter. See
Comment Letter of New Alternatives Fund, Inc., File No. S7-03-04
(Feb. 9, 2004) (estimating a $25,000 cost of ``aids to directors'').
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Some commenters suggested that another cost of the amendments could
result from increased reliance by the independent chairman on the
services of independent legal counsel.\61\ Based
[[Page 39395]]
upon our experience, we estimate that, on average, the independent
chairman will use independent legal counsel a total of 50 hours a year
more under the amendments. We have estimated that the average hourly
rate for an independent counsel is $300,\62\ which yields a total cost
of $15,000 annually, per board. This amounts to $2027 per fund.\63\
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\61\ See, e.g., Comment Letter of Sullivan & Cromwell, LLP, File
No. S7-03-04 (Mar. 9, 2004) (``[W]e believe that mandating an
independent chairman will effectively mandate the retention of an
independent staff and/or enhanced participation by independent
counsel in fund complexes both large and small.'').
\62\ See supra note 36.
\63\ This estimate is based on the following calculation:
($15,000 / 7.4 funds per board = $2027 per fund).
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B. Increased Compensation for an Independent Chairman
We estimate that compensation for an independent chairman may be
from 25 to 50 percent higher than the compensation of other
directors.\64\ In order to calculate maximum likely costs and avoid
understating those costs, the estimate in this section will use the
assumption of the higher end of the range, i.e., a 50 percent premium,
and takes into account the 20 percent increase reflecting possible
increased compensation costs.\65\ Therefore, based on the estimates
discussed above regarding compensation for fund independent
directors,\66\ we estimate that the additional ongoing compensation
cost, and other cost increases, of appointing an independent director
as chairman could range from $1147 to $9000 each year, per fund.\67\
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\64\ See Beagan Wilcox, ``Wanted: Independent Chairmen,'' Board
IQ, July 6, 2004 (citing estimate of Meyrick Payne, senior partner,
Management Practice Inc.).
\65\ See supra text accompanying note 44.
\66\ See supra Section III.A.1.
\67\ These estimates are based on the following calculations:
(($4779 + $956) x 1.2 / 3 x .5 = $1147); (($37,500 + $7500) x 1.2 /
3 x .5 = $9000). Funds that already have 75% independent directors
would only incur costs for the additional pay when one of these
directors is appointed chairman. The costs for funds that must
appoint or elect new independent directors is discussed in the
previous section. We expect that almost all funds that do not have
an independent chairman would select one of the current independent
directors to be the chairman. If a fund chooses to recruit an
independent chairman, however, the fund would incur recruiting costs
in the first year equal to the independent chairman's first year
salary.
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3. Promotion of Efficiency, Competition and Capital Formation
As noted by the Court, we must consider the impact of the costs of
compliance with the two conditions, both quantitative and qualitative,
on funds' efficiency, competition and capital formation. We find that
the costs of the 75 percent condition and of the independent chairman
condition are extremely small relative to the fund assets for which
fund boards are responsible, and are also small relative to the
expected benefits of the two conditions. We expect that the minimal
added expense of compliance with these conditions will have little, if
any, adverse effect on efficiency, competition and capital formation.
Indeed, we anticipate that compliance with the two conditions by funds
that rely upon the Exemptive Rules will help increase investor
confidence, which may lead to increased efficiency and competitiveness
of the U.S. capital markets. We also anticipate that this increased
market efficiency and investor confidence may encourage more efficient
capital formation.
With respect to the 75 percent condition, even for funds that elect
to add independent directors and are required to solicit proxies, the
costs are minor compared to the amount of assets under management. For
funds that choose to comply with the 75 percent condition simply by
decreasing the size of the board, the costs are insignificant. For
funds that appoint three new independent directors, using the data from
the 2004 survey and adding a 20 percent cushion as discussed above, the
ongoing annual costs range from $64,800 per fund, for boards that
oversee only one fund, down to $7037 per fund, for boards that oversee
a large number of funds.\68\ Start-up costs in the first year are
somewhat more per fund: from $100,800 per fund for boards that oversee
only one fund, to $11,624 per fund for boards that oversee a large
number of funds.\69\ For funds that cannot appoint the new directors
and must solicit proxies, the first year costs per fund increase to
$190,800 for boards that oversee only one fund, and to $101,624 for
boards that oversee a large number of funds.\70\ Using any of the
options, the costs per fund will be no more than a very small fraction
of the fund assets for which the fund boards are responsible.\71\
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\68\ See supra note 46.
\69\ See supra note 44.
\70\ See supra note 45.
\71\ We estimate that average fund assets in 2003 were $912
million based on a total of assets in 2003 of $7.414 trillion and a
total of 8,126 mutual funds (excluding funds that invest in other
mutual funds). See Investment Company Institute, 2004 MUTUAL FUND
FACT BOOK, at 113. Fund expenses are typically measured as a
percentage of assets under management and are required to be
disclosed to investors in this manner. See Item 3 of Form N-1A. We
believe that comparison to net assets is the most helpful for
investors.
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The costs of the independent chairman condition are likewise small.
Even if the independent chairman hires two full-time staff (at New York
salaries), and uses 50 hours of additional independent legal counsel,
the total is only $329,639,\72\ which would be divided among the number
of funds overseen by the independent chairman. And the additional per
fund compensation received by the independent chairman could range from
$9000 for an independent chairman who oversees a single fund, down to
$1147 for an independent chairman who oversees a large number of funds.
Even using the highest additional compensation figure, the average fund
will incur a total cost for staff, legal counsel and additional
compensation of only $47,220.\73\
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\72\ Two full-time staff ($314,639) plus 50 hours of independent
counsel ($15,000) equals $329,639.
\73\ Two full-time staff per fund ($42,519, see supra text
accompanying note 60) plus 50 hours of legal counsel per fund
($2027, see supra text accompanying note 63) plus $2674 (increased
compensation and recruiting costs for an independent chairman)
equals $47,220. The increased compensation and recruiting costs for
the independent chairman was calculated based on a board that
oversees 7.4 funds. See supra 60. The estimate of $2674 is based on
the following calculation: ((($27,480 median compensation for a
director that oversees 7 to 19 funds / 7.4 funds) + $743 recruiting
costs) x 1.2 20% cost increase x .5 = $2674). The median salary for
a board overseeing 7 to 19 funds was based on data provided in the
April 2004 MPI Bulletin, supra note 24.
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Whether the two conditions are viewed separately or together, even
at the high end of the ranges, the costs of compliance are minimal.\74\
We also note that the ranges of costs considered above represent the
high range of potential cost of compliance for any individual fund. The
average cost per fund to the industry as a whole will likely be much
lower.\75\ At the time we adopted the rule amendments, 60 percent of
funds already complied with the 75 percent condition and will incur no
additional cost as a result of the implementation of that condition.
Moreover, we expect few boards to appoint or elect as many as three new
independent directors. Most are likely to decrease the size of their
board or add one or two new directors. Our highest cost estimates are
for boards that oversee only a single fund, which is an atypical
situation. We think it unlikely that such a board would choose the
[[Page 39396]]
more costly options of adding as many as three new directors and hiring
two full-time staff to assist the independent chairman.\76\
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\74\ These costs represent our best estimates of the ranges. We
recognize that there may be ancillary costs, but we expect them to
be minor and such costs should be covered by the generous cushion we
have built into our estimates and by our use of the high end of the
cost ranges. Moreover, in light of the benefits, we believe that
even if the costs were several times higher, they would continue to
be minimal and the rule amendments would still be justified.
\75\ While the high-end costs may be applicable to a given fund,
the high-end costs clearly will not be applicable to all funds or
even most funds. It would be incorrect, and indeed misleading, to
take the highest possible cost for a single fund and extrapolate for
the entire industry.
\76\ Because we find the adoption of the two conditions to be
appropriate even looking at the high end of the range of costs, we
would reach the decision not to modify the rule amendments even
apart from our discussion of the rest of the range of costs.
However, we consider that range pertinent and helpful in reinforcing
our determination. Our use of the high end of the range also offsets
any potential benefit from seeking information as to costs incurred
by funds that have come into early compliance with the two
conditions since the date of our original adopting release (which
funds are likely to constitute an evolving subset that may, in any
event, not be representative of funds more generally). As we have
previously noted, engaging in further notice and comment procedures
to obtain additional information would create a risk of significant
harm to investors.
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Moreover, these costs are slight in relation to the very important
benefits of the two conditions, as more fully discussed in the Adopting
Release. The 75 percent condition is intended to promote strong fund
boards that effectively perform their oversight role. Enhanced
oversight by a strong, effective and independent fund board will serve
to protect funds and their shareholders from abuses that can occur when
funds engage in the conflict-of-interest transactions permitted under
the Exemptive Rules. This will increase investor confidence in fund
management and promote investment in funds. While these benefits are
not easily quantifiable in terms of dollars, we believe they are
substantial, particularly in comparison to the estimated cost of
compliance. The independent chairman condition will provide similar
benefits. The chairman of a fund board can have a substantial influence
on the fund board agenda and on the fund boardroom's culture. An
independent chairman 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. Moreover, an
independent board led by an independent chairman is more likely to
vigorously represent investor interests when negotiating with the fund
adviser on matters such as fees and expenses. We find that these
cumulative benefits fully justify the costs associated with the rule
amendments. Further, it is our judgment that, in the future, each of
the proposed amendments is likely, when taken together with other
Commission reforms, to have a significant potential prophylactic
benefit in preventing harm from conflict-of-interest transactions--
itself a benefit sufficient to justify these costs.
Consistent with our view expressed in the Adopting Release, we do
not expect the amendments to the Exemptive Rules to have a significant
adverse effect on efficiency, competition or capital formation because
the costs associated with the amendments are minimal and many funds
have already adopted the required practices.\77\ To the extent that
these amendments do affect competition or capital formation, we said we
believed, and we continue to believe, that the effect would be
positive. Among other things, we believe the 75 percent and independent
chairman conditions would enhance the quality and accountability of the
fund governance process. The estimates discussed in this release of the
costs associated with compliance with the 75 percent condition and the
independent chairman condition, and our further consideration of the
effect of those costs on efficiency, competition and capital formation,
do not alter this conclusion. We believe that a more robust system of
checks and balances on fund boards should raise investors' expectations
regarding the governance of these funds.\78\ By promoting investor
confidence in the fairness and integrity of the individuals that
monitor investment companies, we promote investor confidence in the
fairness and integrity of our markets. Investors will likely be more
willing to effect transactions in those markets, which in turn will
help to increase liquidity and to foster the capital formation process.
Increased investor confidence in the integrity of mutual funds also
will lead to increased efficiency and competitiveness of the U.S.
capital markets.
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\77\ See Adopting Release, supra note 2, at Section VIII. The
costs for any fund are sufficiently small that we think any adverse
effect on competition will continue to be minimal and will be
justified by the benefits of the rule, especially given our judgment
that small funds will choose options for compliance with the
conditions at cost levels that do not approach the upper end of the
range.
\78\ See, e.g., Comment Letter of Morningstar, Inc., File No.
S7-03-04 (Mar. 10, 2004) (``Overall, we support the proposal, which
should be beneficial in restoring the system of checks and balances
that is essential to ensuring that the interests of fund
shareholders are represented.''); Comment Letter of Joseph J.
Kearns, File No. S7-03-04 (June 3, 2004) (``Having an independent
chairman is in my opinion the most important governance regulation
needed. * * * The shareholders need to see that boards are truly
independent including their leadership.'').
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B. Consideration of the Disclosure Alternative
The Court of Appeals also stated that the Commission did not give
adequate consideration to an alternative to the independent chairman
condition, discussed by the two dissenting Commissioners, that ``each
fund be required prominently to disclose whether it has an inside or an
independent chairman and thereby allow investors to make an informed
choice.''\79\ As discussed below, we do not believe this proposal--to
provide information to enable an informed investment decision--would
adequately protect fund investors from the potential abuses inherent in
the conflict-of-interest transactions permitted under the Exemptive
Rules. We reach this conclusion in light of the nature of investment
companies and the purposes of the statutory prohibitions to which the
Exemptive Rules apply.
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\79\ Slip Opinion, supra note 1, at 17. In their dissent to the
adoption of the rule amendments, Commissioners Glassman and Atkins
said: ``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.'' Adopting Release, supra note 2,
Dissent of Commissioners Cynthia A. Glassman and Paul S. Atkins, at
text following n.46.
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As we explained in the release proposing the 2001 amendments to the
Exemptive Rules, funds are unique in that they are organized and
operated by people whose primary loyalty and pecuniary interest lie
outside the enterprise.\80\ This ``external management'' structure
presents inherent conflic