Wednesday, September 19, 2007

Independent Directors Investment Companies part 5

SEC Round Table

Enhancing the Effectiveness of Independent Directors
(Part II)
Mr. Roye: Why don't we go ahead and get started. This is part two of our panel on enhancing effectiveness of independent directors and we have a tough act to follow with panel number one. I think probably during the course of the discussions, we will probably have some overlap and get some views on some of the issues that were raised with the first panel. We may have some different perspectives up here with the group that we have on the second panel. One thing I would like to do is sort of exercise sort of the moderator's prerogative at this point. There was something said in the first panel about the SEC in the Navellier case and the suggestion that there was an allegation of violation of federal law and the SEC stood by and did nothing. And I can't presume to speak for the Commission. I'm just a staff person here. But I can assure the independent directors that are here today that my recommendation as a staff person to the Commission would be that where there are allegations there were violations of federal law, that they ought to be vigorously pursued. And I think that the Navellier case has been reported in the press. There are aspects of it that are nonpublic and people are making judgments on that basis, what's reported in the press. And having been here for three months, you get to see other aspects of what went on. So I think you can't just look at situations like that and come to conclusions and necessarily make judgments. Understand, there is an information base out there that people act on and react to and that's to be expected. But I just wanted to make that statement before we kick off our panel.

We have a distinguished panel today. Harvey talked about his panel being – having black belts and, indeed, the panelists we have up here in Part Two have their black belts as well. To my immediate left is John Haire. John is the chairman of the audit committee and director of the Morgan Stanley Dean Witter Funds. He has served as president of the Counsel for Aid to Education and was chairman and chief executive officer of Anchor Corporation, a registered investment adviser. Next to John is Gerald McDonough. He has served as independent director of the Fidelity Funds since 1989. He is also a member of the board of directors of a number of different companies. He was president and CEO of Leasway Transportation Corporation and he is also a certified public accountant. Next to Gerry is Aulana Peters, a distinguished former SEC commissioner, who is a partner in the law firm of Gibson, Dunn and Crutcher, where she is a member of their litigation department. She specializes in general business and commercial litigation with an emphasis on securities litigation. Next to Aulana is Tom Smith. Tom is another – one of the deans of the '40 Act Bar. He is managing partner of the New York law firm of Brown and Wood. He is a specialist in the Investment Company Act area. He, for 15 years, was co-chair of the subcommittee on investment companies and investment advisers for the Securities Subcommittee of the American Bar Association. Next to Tom is David Sturms. David is a partner in the Chicago law firm of Vedder, Price, Kaufman and Kammholz. Prior to joining Vedder, Price, David was a principal of the investment management firm of Stein, Roe. He is also a vice president and legal counsel of the Stein, Roe mutual funds. He, again, has an extensive '40 Act background and practice.

What we thought we would do is kick off with our two independent directors to give some perspective on the necessity and effectiveness of independent directors from their particular vantage points. And I think what we would like to try to do with our panel is to focus and move more toward how we can improve the governance structure, what types of actions could the Commission explore to improve the government structure, both from the regulatory standpoint, interpretive standpoint, perhaps even from the standpoint of recommending amendments to the Investment Company Act. And Tom is going to focus on the definition of "independent director" and whether or not there are some things that we could do there. Aulana will then focus on some of the structural issues, percentage representation of independent directors on boards, the nominating process. And then we will go to David who will discuss whether independent directors really have the authority they need to act effectively. So let's start off with John.

Mr. Haire: Thank you, Paul. First of all, I would like to express my thanks, which I am sure everybody on the panels and in the audience shares, to the Commission for putting together this two-day process. It has been certainly enlightening to me and many others who serve as independent directors. It has been encouraging to see the depth of understanding of our responsibilities which has come from the panel and from the questions. And I am sure that anyone in this audience who thinks this is an easy job of being an independent director has not been listening to the last two days. One comment I would like to make in that connection is that I have found it useful over the 18 years I have been an independent director, and we always call ourselves independent directors, but we also are, most of us, trustees of Massachusetts Business Trusts. And, to me, the professionalism of this job is much more that of a trustee than it is of a plain-vanilla corporate director, a role which I have also filled with other – with public companies. But there are certain realities in this business that I would like to state, from the outset, come from my own view of the business and where I'm coming from. If you disagree with the principles that I see here, then you may disagree with my conclusions. But, nonetheless, I would like to state them. First of all, it is perfectly clear that the origin of every mutual fund which exists came from the advisory company itself. An advisory company sees a need to offer a financial service product which it thinks will appeal to the public. It does not spring from the independent directors, it doesn't spring from the brow of Zeus. It comes out of the advisory company. And the advisory company lays out its proposal to offer specific services at a specific price in its prospectus and it puts that before the public. And the second step is that investors accept that offer of the proposal of the new fund within the terms of the prospectus.

At that point in time, the adviser accepts the responsibility, the fiduciary responsibility itself, to see that the offer which they have made is fulfilled. And it is at that point that, in my view, the independent director's job comes into play and we become the representatives of the shareholders. Not to reshape the deal into some other deal, nobody at – on the boards of any fund has an obligation to, in my mind, to change the original deal which has been put forward by the adviser and accepted by the shareholder. We do, however, once they are aboard, have the responsibility to see that the bargain is fulfilled in all its respects, that the legalities are complied with, that the service is of a standard that we expect and, as circumstances change over time, we also represent the fund's shareholders in seeing that changes that are made, such as 12b-1 plans, multiple class offerings and every – and derivatives, that those new things which were not on the scene, necessarily, when the fund was originally offered, are dealt with in a way that is satisfactory from the point of view of the fund's shareholders. And that's our only responsibility and it's an ongoing responsibility. We also have had downloaded onto us, and we have accepted from the Commission, many of the enforcement duties which we heard Ron Gilson talk about earlier. And those are very important. We take them very seriously. I had always wondered, until I heard Professor Gilson, why this was such a complex job, being an independent director of a mutual fund, and he made it very clear. It is three jobs. That was, to me, an enlightenment which I wish I had had 15 or 18 years ago.

Now, the other thing that I want to stress, and this you cannot overemphasize: We frequently lose sight of the open-end nature of these funds. The fact that the funds can shrink significantly by redemption is what makes the question of why don't fund directors who are dissatisfied with the performance of a fund change advisers. That is really a step that would be very serious to take because, as we've seen in many cases, you will find that it is – causes a great many shareholders to leave, it causes the fund to shrink to the detriment of everyone. When you have a poor-performing fund from the director's point of view, this is one thing on which there is a common interest in changing that between the independent directors who represent the fund's shareholders and the management company. Management companies are not interested in having poor-performing funds. You can work internally with the investment adviser to see what can be done to shore up or change the portfolio manager. You can usually solve the problem very easily that way. There are a variety of other steps which can be taken to keep the fund intact and improve its management. But in doing all of these things, whether it's wrestling with the changes in size, the economies of scale which we look at all the time, whether it's creating, as I say, new activities such as 12b-1 plans, multiple class, when we get all done, one of the things I think is obvious here, we don't issue press releases, we don't call press conferences and tell everybody, "look what we've done." But I can assure you from my experience with our own funds and from what I know of the other funds, particularly in the major fund groups, this is a job which we take very seriously and which we think plays a very worthwhile role. Now, how do independent directors organize their work load to be effective in overseeing mutual fund operations? I can only give you our own experience and many of these subjects have been covered so I won't cover them at length.

First of all, most of us in the large fund groups have a majority of fund directors who are independent. In fact, a number of things that strengthen that. The fact that if you have a change in control any time in your history for the next three years, you're wise to have 75 percent of your board outside directors. That has had an influence on increasing the number or percentage of outside directors. And, obviously, once those people are on your board, you don't at the end of three years say, well, fine, why don't you all leave because we've met that criteria. So most of us have, as we do in the case of Morgan Stanley Dean Witter, 75 percent or more of our fund directors are independent. Rule 12b-1 requires that the independent directors select and nominate their successors. And I can tell you, as was said in the earlier panel, that over time that provision is very, very helpful in the process of seeing that your independent directors have – bring to the board a diversity of skills which are useful in the management – in the role of overseeing management. I am prejudiced on this one, because I have served in this role for 10 years. But I think it is very, very important to have among your independent directors a lead trustee. He or she will serve a variety of roles, working on agendas so that the board has at its meetings brought before it those matters which are timely and important, new issues which come up where you want a the so-called show-and tell session to better understand whether it's derivatives or anything else you can think of that comes along. The lead trustee also serves as the continuous liaison with the management and can relay to the independent directors and can take back from them questions and get answers for them. I think it's useful. Clearly, you must have, in my view, independent counsel. We've covered that very well. You must have the ability to retain outside consultants for the benefit of the independent directors, both in their annual contract renewals and in any other area that they feel they need. You must have, I believe, private meetings where the independent directors meet regularly with their independent counsel to discuss whatever they should have.

Multiple boards have been discussed today. I personally happen to think, based upon my own experience, that the independent directors have much more leverage with management and much more clout if they represent – if you have multiple fund boards. You can have, if necessary, clusters where you divide, perhaps, your equity funds from your fixed income funds or whatever you want. But you should – your independent directors should represent a significant portion of the adviser's business if you are going to get done what you want done. So at any rate, I think it's a complex job. It requires a very heavy time commitment. Some people say, well, how can you possibly oversee the management of 96 funds. And my answer to that is, how does the CEO of the management company supervise the management of 96 funds? He or she is able to do it by devoting full time to it and by delegating heavily. Our job of overseeing what's going on is not that heavy a job, but it doesn't mean that you meet once a month for a few hours. It is a time commitment and it can be done with a great deal of time or, in the case of Les Ogg's company, an independent director who works full time on it with the staff. And all of these things are available mechanisms for organizing the work of the independent directors in the complex in a way that will accomplish our objectives. Suggestions: Should I give them now or wait until we get through?

Mr. Roye: You can go ahead.

Mr. Haire: All right. In my opinion, there are three factors which have – external factors which have made the mutual fund industry a great industry, basically clean of scandal of any significant size over 60 years. The first one of those factors is the Investment Company Act of 1940 which is one of, I think, the most carefully drafted documents that has stood the test of six decades of work. And how was it drafted? It was drafted initially by a cooperative effort between the SEC staff in 1940 and the industry. And therefore it has worked, I think, extraordinarily well and is responsible for the health of the industry. The second thing is the SEC over that 60 years, which has had the responsibility for enforcing the Act and for taking care of the – watching over the industry. And the third thing, in my opinion, is the existence of independent directors to whom, I believe, the SEC continues to delegate enforcement matters. I had two quotes I was going to use and I will, if I may, a little out of context do only one now. In its 1992 report on corporate governance in the fund business, the SEC stated, "The oversight function performed by investment company boards of directors, especially the watchdog function performed by the independent directors, has served investors well at minimal cost." I think that is still true. I think the job that is being done is more effective now than it was then. What I would suggest that we do at this point forward, or the Commission do, is go back to the principles or the procedures that created the '40 Act that I mentioned before. It was, as I said, a cooperative effort between the SEC and the industry 60 years ago. I would suggest that the Commission consider today a cooperative effort with the ICI, which has already moved into this area of independent director education, with counsel to the independent directors such as Dave Butowsky, whom you heard from this morning, and Dick Phillips whom you heard from, and many, many others, most of whom came out of the SEC in the first place, and with, if, possibly a third group, independent experienced directors, in order to seek ways to have these best practices which I've outlined above available to assist independent directors of those fund groups which feel they have not had the resources available to do what we've been able to do in all the major fund groups that I have had experience with, in order to fulfill more effectively those independent directors' fiduciary responsibilities to fund shareholders. A modest step, a small step, but one that I think would be very helpful, as Les Ogg said, bringing these principles to others of the 1,500 independent directors that serve around the country. Thank you.

Mr. Roye: Thank you, John. Those were good suggestions. I do have a question. You referred to Les Ogg, and I think he is fairly unique in the industry in that he works for the fund –

Mr. Haire: Right.

Mr. Roye: He works for the directors –

Mr. Haire: Right.

Mr. Roye: – Not for the advisers.

Mr. Haire: That's correct.

Mr. Roye: Why isn't that paradigm copied in other fund settings?

Mr. Haire: I think it could be. During the time that I have been the lead director at Morgan Stanley Dean Witter, had I felt the need for internal staff, legal or otherwise, all I would have had to do is ask for it. Instead of that, I relied on our outside counsel and on consultants to develop the material that I needed in order to carry out the responsibility. But it's perfectly excellent. In fact, when Dave Butowsky and I were putting together the structure that we now have, we visited Les and Bill Pierce in Minneapolis and took as many leaves from their book as we felt were appropriate to our situation.

Ms. Peters: Paul, may I comment on that? I don't know why the formerly IDS, currently American Express structure is not copied more throughout the industry. I am very familiar with it because, as you may know, I served for about six or seven years as an independent director for that very same mutual fund complex. And I just want to put a pitch in for that structure. If people are contemplating changing the current – their own current structure, to the extent that you are a large enough complex to warrant the expense, I think that a small fund probably could not afford to have a staff. American Express, when I was there, it was IDS then, had not only the chairman or president of the fund who sounds to me to be roughly the equivalent of John's lead trustee, there was a chairman of the fund, Les, who's a vice president and legal counsel – oh, there he is – a secretary and two or three support staff. And I have to say, as an independent director, I turned to all of the staff members, more often than not to Les. He probably rues the day that he said, "Come to me with any questions that you have," because he certainly got them in spades. But I think that, as an independent director, you are quite ready to turn, on a moment's notice, to your counsel if that counsel is on staff and right there, rather than jump through the hoops, perhaps, to call outside counsel, although that clearly is an alternative. But it may be, perhaps, you wait until something major or bigger or more important in your own mind comes to mind before you go through the rigmarole of calling outside counsel. That is just my pitch for that particular paradigm. I think it's an excellent one. But, of course, you have to have as good a counsel or lawyer there as Les Ogg. But I am sure there are others able to follow his lead.

Mr. Sturms: Paul, if I could comment on the subject while we've opened up the door and it was opened on the last panel also, a strong recommendation was made at the last panel that independent directors should have separate counsel and there is a pitch made for the Les Ogg structure. And I think that structure, maybe not in its exact form, does exist in a number of different forms today. One of the things in my outline I addressed is this concept of whether or not the Commission should require separate counsel for independent directors. And I have actually participated in and have been involved in all kinds of different structures. And sometimes, people don't know what that means. It was talked about a little bit earlier. There is a structure, which is the classic or ultimate degree of separateness, where you have counsel for the independent directors, counsel for the fund and counsel for the adviser. There is the other structure, which was suggested at the last panel as the ideal structure, which is counsel for the fund and the adviser the same, and counsel for the independent directors being separate. There is the third, which I actually think is probably the most efficient and maybe models the Les Ogg theory, which is where counsel to the fund and the independent directors are the same and separate counsel for the investment adviser. The theory there is that the independent directors and the fund's interests should always be aligned and therefore have the same counsel. And rather than just separate counsel for the independent directors that gets consulted whenever the other counsel thinks it's appropriate, if your counsel is in there as fund counsel on a daily basis having access to the information, deciding when there is a conflict in your Section 17 and helping frame those issues, it's much easier then to advise the independent directors. Well, people argue there may be different ways to achieve these goals. One thing I've noted in reviewing the Investment Company Act is that the Act requires that, for purposes of independent accountants, that the decision to employ which independent accounting firm vests solely with the independent directors. And maybe what should be considered is not only a best practice of counsel but also vesting solely in the independent directors' hands the decision for who the counsel should be and which structure should be employed.

Ms. Peters: I agree with your comments, David, really. Because I don't see the conflict that the other panel suggested might exist or arise if you had the same counsel for the fund and for the independent directors.

Mr. McDonough: We have, at Fidelity, counsel for the fund and counsel for the independent trustees are separate. However, Dick Phillips, who is counsel to the funds, is at every one of our meetings, including the executive meetings held by the independent trustees monthly and, should we meet for any reason off of that monthly schedule, he also is there. So we have the two fellows who would be most capable of representing our interest as trustees and the funds' interests at every meeting. They are never with us individually when we are dealing with Fidelity matters.

Mr. Roye: John, you mentioned the service on multiple boards. Intuitively, one would think that there is a certain number of funds and portfolios that it just would be impossible to oversee. Have you thought about how far you can go in terms of overseeing the number of funds or portfolios?

Mr. Haire: Really, Paul, my answer to that was the answer I gave you. If the CEO of the investment management company can supervise that many funds, so can I oversee what he is doing. It may take me more time but I'm about to retire but I would have been perfectly willing to have devoted full time to this. In fact, I resigned a full-time outside position in order to take on this assignment and give it whatever time it took. So I don't think there is a finite number.

Mr. McDonough: I would agree, John. You know, our independent trustees at Fidelity, we oversee 285 or more boards and it's no burden at all if you stop and consider what our responsibilities are and the extent to which there are very few items that are unique to a single fund. Clearly, performance can only be measured on a fund basis, and the expenses can only be addressed on a fund basis. And I don't think other than if there were to be compliance issues of that type which would be very, very periodic in nature and timing, everything else that any one of us do if we have more than one fund under our oversight, are things that when you do them you are doing them for all funds simultaneously. Therefore, I don't know where the finite number is, frankly. We haven't reached it in our view at Fidelity yet. They open new funds and we put them right under our wing.

Mr. Smith: Gerry, how often do you meet?

Mr. McDonough: We meet once a month for 11 months.

Mr. Smith: Because it really is a matter of work load, I guess, you meeting 11 times and –

Ms. Peters: Some funds only meet four times a year.

Mr. McDonough: We meet 17 separate days a year.

Ms. Peters: Just briefly, I don't know if there's a limitation beyond which you cease to be effective but when I was at IDS we had two presentations a year on the performance by the portfolio manager of each fund. And we didn't have 285 funds. So I am not quite sure if there is not a practical limitation on –

Mr. McDonough: The way we handle it, Aulana, is we have three –

Ms. Peters: It's a performance issue.

Mr. McDonough: We have three subcommittees of the independent trustees, one for equity funds, one for fixed income, one for special and select. We meet every month with portfolio managers and over the course of a year we see every portfolio manager.

Ms. Peters: So you divide up the work?

Mr. McDonough: Yes.

Ms. Peters: And, whereas our entire board met with each portfolio manager. But there are ways – there are different ways to – I guess I should say "slice the cake" rather than "skin the cat."


Mr. Roye: I think one of the other criticisms you have when you read some of the articles criticizing directors for serving on multiple boards, and this relates to a question that came in from the audience as well, is that it is sort of popularly reported that directors who serve on multiple boards receive compensation levels that some may call into question whether or not directors are afraid to challenge management for fear of losing their jobs.
Mr. Haire: They won't lose their jobs. I mean, that's what nobody seems to get here. We may be overpaid but we set our own compensation –


Ms. Peters: Never, ever. Whoa. You do need independent counsel. You never make an admission like that, not even hypothetically.

Mr. Haire: We set our own – No, I mean, it's been said. We set our own compensation and it is paid by the fund.
Ms. Peters: That's true. And you're not overpaid.

Mr. Haire: But as to the issue of independence from the adviser, that is a non issue.

Ms. Peters: That's true. I agree with you.

Mr. McDonough: It may be another issue but it's a non issue.

Mr. McDonough: I don't know why – Dealing with intellectually brilliant people that we do from this industry out to our critics, that concept, it's plain English, there's no way that I could explain why that is so hard for people to understand. Yet we continue to be beaten with that stick by people who don't understand the English language, I guess.

Mr. Haire: Well, let me say, in the selection process, when we, as independent directors, are seeking candidates to fill out our board, the caliber of people that we have been looking at are not people who are going to travel across the United States 17 times a year for $30-, $40,000, and forgo bank directorships at the same time.

Mr. Roye: I want to keep this moving with going to Gerry next. But let me just – I mean, you guys sit on boards where there are a majority of independent directors. And technically the statute only requires that 40 percent be independent. I mean, doesn't an independent director in that sort of structure with a 40 percent – there's only 40 percent of them, I mean, can't the adviser effectively get rid of the independent directors in that scenario?

Mr. McDonough: Paul, I think you're right that 40 percent is the legal requirement. The ICI study, I believe, last year indicated that in excess of 90 percent of all funds have boards which consist of at least a majority. So it may be apparently a problem. In the real world, at the moment, today, it really isn't because, in fact, we do have a majority, at least, of independent –

Mr. Smith: Section 10(b) requires it in many instances. It certainly would in yours, John. And 15(f), they require 75 percent in a lot of instances.

Mr. Haire: That's right. The recommendations in the SEC's 1992 study for legislative changes were very sound recommendations. Unfortunately, they did not pass. They were, as I recall them, the majority had to be outside directors. The outside directors had to select and nominate their successors. As a practical matter, in most fund complexes, both of those things have been achieved, either on the 75 percent, because, as I mentioned, change of control or because they think it's good policy and because all of the large groups, I'm sure all of the large groups, have 12b-1 plans. They have it there. So, while the legislation did not pass, the practical effect of its failure to pass, I don't think, is of any consequence.

Mr. Roye: Should we, as regulators, be concerned about the 10 percent?

Mr. Haire: Sure.

Ms. Peters: Sure.

Mr. McDonough: Sure. I'm going to give you the right number, without fear of contradiction. I have the right number in my presentation. Those of you who were expecting to see Don Kirk here, who had originally been planned to be our FMR representative on this panel, he contracted a southeast Asian parasite on a trip to Vietnam in November and came down very, very seriously ill about 10 days ago. It was identified after four or five, six days of analysis and blood work, and he is now starting treatment to purge that from his liver, of all places. It found a home. So those of you who were expecting him, I hope I can fill in for him adequately today. The general structure of the mutual fund industry, wherein the adviser firm, the fund and several administrative providers each have a role in serving the investors, demands that independent trustees effectively represent the shareholders' interests in order to ensure that conflicts of interest are resolved in favor of the shareholders each and every time they arise. And since the board of trustees includes both interested and independent members, the latter must clearly be in the majority. And I hope that at some point it is required either by operation of law or regulation that independent members constitute at least 60 percent of every fund board. At Fidelity, we are 75 percent. Critics periodically challenge the true independence of the independent trustees. They generally allege that trustees are unwilling to aggressively represent shareholders out of fear that the adviser will remove them as trustees or eliminate or drastically reduce their compensation. The truth is that advisers can do neither.

The independent trustees determine their own successors and they set their own compensation. If one or more independent trustees fails to act appropriately, it cannot be out of concern for either continuation in the role or compensation for the position. The need for independent trustees to represent fund shareholders is self-evident. Representatives of the adviser firm and various other service providers cannot be expected to successfully achieve their legitimate need for income while simultaneously limiting the costs charged to the funds for a service level determined solely by the adviser and the others. Law and regulation long ago established that shareholders are not required to vote with their feet as their only option when stewardship of their financial assets is the subject. Independent trustees must not only evaluate the cost with respect to investment advisory fees but are obligated to determine which services must be provided shareholders by operation of law and regulation and the fair costs thereof. The cost of additional services proposed to be provided by the adviser and others must also be evaluated by the independent trustees and the associated cost must be negotiated by them on behalf of the shareholders. Furthermore, the shareholders' need for, and desire to have, these services must be confirmed by the independent trustees and periodically reexamined to ensure they are of continuing value to the shareholders. There is no valid excuse for independent trustees when constituting a majority of the board, to fail to effectively represent the shareholders. By definition, if they are a majority, they outvote the interested trustees. Since it's in the economic interest of the adviser to do a good job in a cost-effective manner, there should exist a common desire between interested and independent trustees to provide superior services at the lowest practical cost.

The mutual fund marketplace will help both sides keep their eyes on that ball in the long run. In the short term, however, the independent trustees have more than adequate resources to negotiate effectively. Legal counsel for the independent trustees, counsel for the funds, auditors for the funds and service providers can be brought into the process to provide necessary data and aid the independent trustees to determine the reasonableness of any proposal put forth by the adviser. There is a long history in our country of third party responsibility for the protection of certain assets owned by the public but temporarily in the hands of a custodian. The management and custody of financial assets and instruments have required an extremely high level of fiduciary responsibility. Mutual funds certainly are included. In fact, mutual funds may now be that asset class which most requires the oversight of independent trustees. Mutual funds are now the repository for trillions of dollars that will determine the quality of life for an ever- increasing number of our citizens. The near elimination of employer-paid pension benefits and the concerns about the amount and availability of government-provided post- retirement benefits has resulted in a dramatic shift in the minds of our citizenry. Employees and their families know that the quality of their post-retirement years will be a function of how many dollars they have saved and how successfully those dollars have been invested. Mutual fund holdings no longer represent just invisible and discretionary assets for they will be the primary source of retirement income needed by our aging population.

The role of independent trustees will take on greater significance in the future and will require that those persons filling the positions be intellectually capable of dealing with complex financial matters and arcane laws and regulations in an environment where fiduciary responsibility continues to be obligatory. The adversarial role, not confrontational, but adversarial, role of independent trustees and fund advisers is a healthy and desirable one. It should be promoted by all of us. It is not possible for an independent trustee of a single fund complex to have an informed opinion about the detailed quality of governance of other fund complexes. We can only evaluate the macro statistics, and they are not particularly helpful in reaching conclusions that might lead to regulatory actions. To the extent, however, that the independent trustees of other fund complexes conduct themselves as do we at Fidelity, all shareholders are being well served. Two recent actions might illustrate this point. In response to market share and share price driven increases in the rate of growth of the Fidelity fund assets, the board established in 1993 an ad hoc committee of independent trustees to study economies of scale. That committee evaluated appropriate data over many months and reported its conclusions to the full board. Adjustments were made in the asset-size-driven sliding scale of adviser charges, reflecting the judgment of the independent trustees as to the existence of economies of scale. We then formalized the initiative by creating a permanent committee on service fees consisting solely of independent trustees. This committee monitors the cost borne by the funds to ensure that changing conditions are reflected in lower fund costs. Another new permanent committee of independent trustees was created by the board in 1996 to monitor the broad subject of distribution costs. This committee ensures that all shareholders of a given fund are treated equitably regardless of which of the multiple distribution channels was the vehicle for that shareholder's investment. Regulators should aggressively administer the law- based restraints designed to protect the shareholders and their assets housed in mutual funds. Regulators should passionately support independent trustees when conflicts arise between them and the adviser firms, especially when the advisers appear to be guilty of not dealing openly and fairly with shareholders. And all of us, regulators, independent trustees, advisers' representatives, independent counsels and responsible, knowledgeable observers of the industry should respond to the inflammatory and inaccurate utterances of critics who would undermine the confidence of US mutual fund shareholders. They offer unsupported charges and allegations with impunity and evidence no embarrassment when challenged to support their ratings or when contradicted with a persuasive showing of the facts. The mutual fund shareholders of this country are being served well by the regulators and independent trustees of most funds. Those shareholders are entitled to a fair and knowledgeable presentation of the facts. Thank you, sir.

Mr. Roye: Gerry, let's assume that there's a vacancy on your board that you have to fill and you're on the nominating committee of the board to fill that vacancy. Could you maybe outline how you would approach that process and the type of director you would be looking for, the skill set, the traits you would be looking for? In the last panel, Willie Davis was sort of held up as a perfect, sort of intimidating, imposing director, not afraid to ask the tough questions. Could you maybe outline for us how you might approach that?

Mr. McDonough: As any of you who saw Willie or know him know, he is one large man and he pointed out earlier when we were talking that he used to have a friend who was on a panel with him and said, well, we're going to call the photographers down to take a group picture of you.


Mr. McDonough: We, in fact, right now, Paul, are in the process. We have a mandatory retirement age at Fidelity. We must retire from the board as independent trustees at December 31 of the year in which we reach age 72. We have one director going off December of this year and myself, I am chairman of the independent trustees, I and another director will be retiring at the end of December of the year 2000. So we have got an ongoing process. We have a nominating committee consisting of three independent trustees and we have a profile of the, if you will, the ideal candidate. It generally includes someone who will have something approaching 10 or more years to serve on the board. Even a financially trained person coming on that board has a learning curve to go up. The nuances and the peculiarities of a Fidelity versus any other experience they may have had, and we want that person to be able to serve for a reasonably long period of time. So we are looking for someone in that age bracket, someone who has occupied a very senior role, maybe one, two or three in a major US corporation or its equivalent. Looking for people who can deal with complex problems, know how to ask questions. They are able to have the hair on the back of their neck stand up, even though they may not be expert in a lot of different fields. When they hear something that might be attempted to be being wrung by them, the hair on the back of their neck stands up and they have been there. They have generally multiple degrees, they have 35 years in the business world, many of them at very senior levels. They are interested, dedicated people and they will not sit passively while a presentation is made that contains questionable items. They will represent the shareholders. We are looking for people, clearly, who don't have existing conflicts of interest, unless they are willing to get off of bank boards or whatever the conflict might be. And most importantly, we are looking for people who are willing to do the work. We are not looking for people who want their name on the letterhead. We are looking for worker bees. We have nine independent trustees. Each one of us represents 11 percent of the hours available to do this job and we can't, frankly, afford to make an 11 percent mistake in letting somebody come on who has a singular agenda or who is looking to see how many times he can get his name in the paper and, frankly, there are – there are men who head major US corporations who would be the last people who would be able to serve our shareholders well because, among other things, their attention span wouldn't permit them to deal with the three three-ring binders of material that we get delivered to our homes a week before every board meeting. So we are looking for people who have, obviously, the highest integrity, knowledge, willingness to deal with difficult subjects, willing to go eyeball-to-eyeball with the adviser when it's necessary, confident that we've got all the ammunition we need, frankly, in our arsenal to hold the day. We will win the day in any argument or discussion with our adviser, frankly, because we've got all the ammo. That's pretty much what we're looking for.
Mr. Roye: Aulana?

Ms. Peters: Well, I'm feeling very much like Les in that my assignment was talk about what the percentage should be for independent directors on a board and how should you go about finding them and what should the nominating process be. So my comments will be brief and then, perhaps, I will comment on some of the issues raised in the earlier panel. Although I've been asked to cover material that's already covered, I'm kind of not surprised that I had a slightly different approach to it. And on the question of what, perhaps, is the appropriate percentage of disinterested/independent trustees or directors that should be included on a mutual fund board, I first asked myself the question of what was the overriding purpose or function of the board and that, of course, is an easy one. I'm sure you've been hearing it now for two days. We're there to perform an oversight function. That function in the context of a '40 Act company is definitely much more hands on, as previous panelists pointed out. That is a direct function of the nature of the Investment Company Act. There is a lot more to do. As Les Ogg liked to remind me over and over again when I served as an IDS independent director, the hands on function was also a result of the Commission delegating down to the independent directors what has been labeled the enforcement responsibility. I stopped asking Les, "Why do I have to do this? Why do I have to get involved in ascertaining the fitness of some custodian bank someplace?" And he would always look at me and smile and he said, "Because when you were a commissioner, you voted to assign this responsibility to the independent directors." That was the answer over and over again so I stopped asking the question and reaped the pain of my own activism – folly. I call it activism; he calls it folly.

But, in any event, we are supposed to be there as overseers of management and I thought that the comment on the – by Dick Phillips, who is a wise gentleman, that oversight is more in the way, in his view, of imposing a discipline rather than being a watchdog-cum-policeman is a very good way of looking at it. That being the case, it is my view that in order for a board to function effectively and an independent member of that board to function effectively, the disinterested independent director should dominate. And I don't have a percentage but I have sat in a lot of board meetings and other types of meetings and I think that, for me, my conclusion was dominate means outnumber. I'm talking like a litigator; that's because I am one. You outnumber. That, again, doesn't mean you need enough mass to be confrontational. You can be very, very effective without being confrontational. But, as Gerry said, you should have an adversarial approach. So I didn't come up with a number like 75 percent or 60 percent. My experience, however, Paul, dictates that for a board to have a chance of operating truly independently of its creator which, in our context, is the investment adviser, that there should be at least – the number should be two to one; two independents to one person – at a minimum – one person from the adviser. I think that my colleagues are correct that it's usually somewhere around three to one, which gets you up to the 75 percent level. But percentages are a little dictatorial and I think that, depending on the board's size, if you use two to one as a minimum and then go on up to three to one or whatever you can afford, you will get the requisite, or at least the desired, level of independence so that the dynamics within the board room are balanced and create an atmosphere I where management – it is clear that management is accountable to the board. And that, after all, is what you want as opposed to slavish adherence to percentage numbers. You want management to be accountable to the board and, in that kind of an atmosphere, I think, you have a condition that facilitates changes in government and, where necessary, changes in management. Although I think that that is probably a rare occurrence because I agree with Gerry and John that when the independent directors speak, the advisers do listen and it is not that difficult.

Perhaps we are speaking from a rarefied atmosphere of large complexes but I do think the advisers react to and respond positively to demands and suggestions from their independent trustees. With respect to the nomination of disinterested directors, I didn't come up with any hard and fast rule with which I felt comfortable, principally, I think, because I've seen the process work well with the adviser taking the initiative and nominating committees of the board taking the initiative. However, as a guideline, I think that it is always – it is helpful and it is good practice to have a nominating committee on the board, whether the idea or a name of a candidate or a potential candidate only and forever must always come out of that particular committee, I doubt that, that that is necessary. But it is a good way to vet nominees or candidates. I think I would go so far – I don't think - I know I would go so far as to say that it is an essential way to vet nominees because it is not a good idea to have the adviser or the CEO of the adviser, whoever that might be, be the sole decision maker on who should serve as a disinterested member of the board. In terms of practice, I would have more than one person interview potential candidates, at least three or four people should be interviewing independent or potential independent directors. And there is an interesting question to raise as to whether the board or the adviser should be the only source of nominees to the board. I don't quite know how this would work in the '40 Act context but, of course, when you serve on other public company boards, frequently people want to be directors, nominate themselves. Or shareholder interests, special interest groups nominate themselves, as well. That didn't, I don't think, happen too much at IDS. Nevertheless, that's something to explore perhaps after –

Mr. Roye: I would think that if the directors are truly independent, they should feel free to seek out candidates beyond those who are suggested by management.

Ms. Peters: Absolutely, and they do, in my experience. It is not necessary to have, I think, a driving force outside of the board to bring candidates to the board. There is one thing that I think helps in keeping people alert, alive and independent and one thing that I think all boards should have and not all boards do have and that is a mandatory retirement age. The good boards have it. Others do not. I would make that age a little lower than 72, at least by two years. That's not to say that one doesn't add value and play an important role past the age of 70 but I just think that it's a good time to invite people to say, adios.

Mr. Smith: I might point out to you that the AARP funds do not have a retirement age.


Ms. Peters: No doubt. No doubt. But there is a special constituency there. Let's call it a personal prejudice. And I'm not that far – well, I guess I am. I shouldn't pretend to be looking down the hall at the age of 70. But I do think that a mandatory retirement age ought to be sine qua non and if I were asked what it should be I would say 70. There was a point that I wanted to make about the nomination of candidates and why I would not care to see or think it's advisable to have an across-the-board prohibition of having the adviser being involved in that process, restricting it solely to disinterested directors. And that is that, you may understand just by looking at me, the peculiarity perhaps of this viewpoint. But I think that sometimes the corporate entity in the form of the adviser can more easily effect changes in terms of diversity, if they are involved. The president of a particular mutual fund complex once said to me that he thought it was sometimes difficult to get board members to consider candidates that come from different types of backgrounds or look like people different from themselves. And an outside adviser might go and try to diversify before the board might. That certainly wasn't true of my board and – my board . . . I'm proprietary, right? The IDS board. And I am confident that it is not the case at Fidelity and Dean Witter. But it is an argument to have to maintain the involvement of the adviser.
Mr. Roye: What about the – I guess yesterday John Markese suggested there was a disconnect between directors and shareholders and I think he threw out the concept of having shareholders when there are vacancies be in a position where they could nominate potential director candidates. Is that something that is workable?

Ms. Peters: First of all, I do not agree with the premise that there is a disconnect between the shareholders and board members. The last time I looked, the one best practice that seemed to be adopted by virtually absolutely everyone is that if you are sitting on the board, you have a substantial financial interest in the funds. And I don't know of any circumstance where that does not exist. So if we accept the premise that our executives and our directors are – have an interest that is at one with the shareholder because they, too, are shareholders and therefore are going to work in their own interest as well as the shareholder at large, I don't think that it's necessary to say that the shareholders themselves should be able to nominate. I wouldn't say that they shouldn't because our corporate governance process allows for that. My concern about instituting it as a rule of law or, God forbid, a best practice would be that the people that will take advantage of it would be special interest groups and –

Chairman Levitt: Why do you say "God forbid, best practice"?

Ms. Peters: Oh, you're going to hear. Because I have a real concern about the Commission or industry groups establishing lists of activities or criteria or standards as best practices and imposing them across the board as a rule of thumb that must be followed in every circumstance. What happens, Mr. Chairman, when that occurs is what the public bodies or the industry groups come up with, probably 90 percent of it, are best practices. They codify what is already in place as a best practice and then they add a couple of fillips, bells and whistles that, in my mind, create more havoc than create a situation where it will facilitate or improve. I have specifically in mind the recent pronouncements that came out of the Blue Ribbon Panel that was fostered by the NASD and the New York Stock Exchange where I think there were 11 or 10 recommendations that should be implemented as best practices with respect to audit committees. And most of them are already in place and I think that that should be promulgated somehow. But two of them, requiring the audit committee to conduct almost another mini-audit of quarterly reports, and to issue a report of its own stating that it, the language I think is "believes" that the financial statements are fairly stated, is going to create a serious problem with people being able to serve on audit committees because they are not going to have the time or the resources to go behind their outside auditors and their inside auditors to make the determinations that should be required by that type of attestation. And it is the same thing, a point that Les made, every time we delegate an enforcement duty or obligation like that onto a committee of independent directors, what we are doing – and this may not always be bad – is laying the foundations for fostering additional cottage industries. Because, basically, the outside director is going to have to go hire somebody to do it for him or her. And even if they are retired and only doing this 100 percent of the time, which a lot of people are not, in order to – what was the word? – protect themselves. I am not sure – I am confident, or at least I have the opinion that that does not advance the regulatory oversight scheme a whole heck of a lot. So that's why I'm very cautious and very concerned about reports. It's kind of an easy thing to do, but reports coming out under the guise of "these are the best practices in the industry" because they become the standard.

Chairman Levitt: What do you think we should do with this two-day effort? What should result from this in your judgment?

Ms. Peters: Well, there are – I think that there are some things that you can do. Let's go back to the '94 report – '92 report. And let me go back to it too because now I've read it so long ago that I can't recall some of the recommendations. But some of the recommendations were good, some of the staff recommendations were very good. And I think you should pick and choose those that are not going to hamper this industry and that would help achieve some of your goals and propose legislation on it, like maybe retirement ages or change the percentages. Sixty/forty representation, 40 percent representation of outside directors, I don't think, is currently viewed as the best practice. Let's have our statute reflect what is the best practice in that regard. But pick and choose silver bullets and don't make broad statements about broad standards that may impose obligations and duties on outside directors that they cannot, by virtue of the structure itself, in my view, meet.

Mr. Smith: On best practices, I would submit to you that that AARP board works very well.

Ms. Peters: I'm not going to argue with you, Tom. Because I am going to be here some day. I already am a member, a full-fledged member of the AARP. But be that as it may, let's not take it any further or I'm bound to say something someone is going to hang me with later.

Mr. Roye: Tom, what about the definition of "interested person" in the statute, which is how we get at independent directors? Does it work, does it make sense, can we refine it, improve it?

Mr. Smith: I guess inherent in that question is whether or not you're getting the right people presently to serve on boards. And those of you who have been here the last two days and have seen these independent directors, I guess it would be a resounding yes. Now, this doesn't represent everybody but I think the proof is in the pudding in that you have an industry here that is a model for the world. There was an article in The Economist two weeks ago that was talking about the European fund industry and was – pointed out that fees here were much lower and disclosure here was much lower. So I don't think there is anything fundamentally wrong with your definition of an independent director. I might just make a couple of general comments. One is you don't want to make that definition too restrictive. It is hard enough as it is because you rule out broker-dealers, you rule out people that hold stock in the investment adviser, the principal underwriter. You don't – you don't – you rule out counsel. You don't want to make it too restrictive because you do need a broad body of people. You want to avoid what I would call a Judge Ito syndrome when he said nobody could serve on the O.J. jury who read the daily papers. So you want to be careful in that regard. The other thing, you want to be clear as to who is and who isn't an interested person because it's vitally important that your board be properly constituted. If you don't meet your 40 percent or your 50 percent test, whichever you are subject to, the actions of that board are deemed to be invalid and the fees may have to be paid back to the fund and so forth. And one thing – so I think in defining interested people, whether it's your position on multiple boards or what have you, you want to be very clear. You want a bright line test so that people don't make mistakes. And in this regard, I would advise boards to give themselves some leeway. Don't go four-three, go five-two. So if you do make a – if someone inadvertently becomes an interested person, you're not out of whack. But there has been a lot of talk about independent directors and their ability to get information from the advisers and Les Ogg has been held up as a wonderful example of something that works. I would submit that there is more than one way to do this and the – I would point out that the advisers have a great interest in having a strong board. In terms of the selection of directors, I think it should be a collaborative process. I would agree that the independent directors need to have a role, maybe the dominant role, in the selection. But I think it should be a collaborative process because it is equally in the interests of the advisers to have a strong role in this, to have a strong board. It is a great protective device to them to have a strong board. And I think they should work together. I would point out that – you were talking about why don't more fund groups adopt – have independent employees as Les. The industry as a whole does not have that and it works very well. And I think that's because the advisers have an interest in providing the information and cooperating with the independent directors. On the subject of the multiple – serving on multiple boards, I might point out in response to Professor Coffee's comments that Strougo which got us here did have a Brazilian on that board, they did have a Portuguese speaker on that board.


Mr. Smith: And they still got in trouble with my friend, Judge Sweet. On the subject of how much you are paid, the substantial compensation, this is a question of fact. And if you get a suit, the plaintiffs are going to come after you on that point, as to how much you are paid really undermines your independence. And I would point out that in each of the five excessive fee cases that were tried in the '80s, that was before the judges. And in each of those cases, the judge found that, indeed, the directors were independent, despite however much they might have been making. But there has been a lot in the press about this. It is required now that it be disclosed as to how much the directors make. And it has raised the consciousness of the fund groups and the independent directors on this regard. And I guess my only comment is, you want to be careful; you don't want to lead with your chin too much on that one. But I also agree with you, John, when you say you've got to pay. You get what you pay for and I think there's a balancing process there. There are – Mr. Chairman, you were quoted this morning in the Wall Street Journal as raising questions as to whether or not it is proper for a member of – a retired member of the investment adviser to then be considered as an independent director or should there be a two-year period or what have you. I think that's really leading with your chin. If you have a chief executive officer or someone who is really dominant with the investment adviser who would then be considered to be an independent director. I would point out that I don't see it very often because if he still owns voting securities of the investment adviser or the principal underwriter, he is not going to be independent. But I think if you wanted to tweak this a little bit, if they're lawyers, they have to be off two years before they can come in. There would have to be a two-year hiatus and that might be appropriate there. There is something beyond what is in the statute that you consider when you pick new directors. You've got to look at material business relationships and, quite frequently, in the selection process you will rule somebody out, although technically they are independent, because of relationships. But it is hard to legislate that.
Chairman Levitt: I don't think you get at this problem by rules and regulations. It is a question of whether it passes the smell test. And that last example smells.

Mr. Smith: Right. I don't see that.

Ms. Peters: I'm happy to hear you say that, Mr. Chairman, because I think you are absolutely right. I don't think that we can legislate independence. Independence, really, you either will have an independent spirit and mind and point of view or you don't and it doesn't matter how much you're paid or whether your investment bank does business with the mutual fund. The trick is to have this nominating committee and the adviser be able to recognize it when they see it. I think that they will hire it when they see it as well.

Mr. Smith: Paul, I had four or five examples that I think it needs more clarity as to the definition of what's an interested person and I'll just write you a letter and set them forth.

Mr. Roye: David, do directors need more authority to be effective?

Mr. Sturms: An interesting question and I think it goes back to the purpose of why we're all here and I want to thank the Chairman and others for inviting me to participate in this. I think there has been, for some time now, some criticisms as to whether or not independent directors are effective. And I go back to the basic question which is, what do you mean by "Are independent directors effective?" At the very first panel yesterday, Ken Scott raised the question about what the standard should be. Should independent directors be the advocates and chief negotiators for the shareholders to bargain fees down as low as possible or should they simply be at the other extreme which is to watch out for violations of Section 17 or extreme conflicts of interest. I think you need to figure out what the press wants people to do, what the Commission wants people to do and then you have to figure out, as an independent director, what do you want to do. Given the practicalities of the system, what can you do and what should you do? Again, going back to what Mr. Scott said, I think there is a big disconnect between theory and reality in the industry today. And maybe not in the minds of independent directors but maybe in the minds of the Commission and in the press. In theory, a fund is owned by the shareholders who hire the directors to run it and the directors select the service providers, including the investment adviser. In reality, a fund is created, sponsored and operated by the adviser and it is the adviser and not the directors that the shareholders buy. Given this dichotomy and this conflict – not conflict of interest but conflict of what should be the right result, let me read a commentary on independent directors. "Recent discussions of problems in the mutual fund industry contain numerous statements of opinion that, in many cases, independent directors of mutual funds have not performed an effective role in safeguarding the interests of mutual fund shareholders. Independent directors normally lack the power to exercise meaningful restraints on the investment adviser." I always like to quote Yogi Berra whenever I can. Yogi said once, "it's de ja vu all over again." What's interesting to me is that is not a current commentary but a 1967 law review that was commenting upon independent directors.

Indeed, back in 1966, the Commission itself stated that, in the Commission's experience, the administration of the Act, in general, the independent directors have been in a position to secure changes in the level of advisory fees in the mutual fund industry. In essence, negotiations between the independent directors and fund advisers lack an essential element of arm's length bargaining, the freedom to terminate the negotiations and to bargain with other parties for the same services. In view of the fund's dependence on its existing adviser and the fact that many shareholders may have invested in the fund on the strength of the advisers reputation, few independent directors would feel justified in replacing the adviser with a new and untested organization. It has been talked about earlier in the days that independent directors have basically the pea shooter or the nuclear bomb. I was recently working with an independent board that was going through a change of control and I described a lot of the situations, the legal theories that are available to them and the practicalities of the situation. And one of the independent directors looked at me and said, you know, David, you make me feel like I'm at a poker game and I've just been dealt a royal flush and I look down and I don't have any chips. I think it is that notion between the theory and reality that has caused some people to say the system maybe should be changed in total. I've heard people say that independent directors don't hold down fees, they don't replace poor performing advisers and that means the system doesn't work. I've heard people compare independent directors to ERISA trustees and say that the fiduciary duty is the same but yet, in the ERISA context, fees are heavily negotiated and advisers change all the time. I've heard that we should go to a modified, unified, unitary investment approach. All those things are interesting suggestions that maybe merit some debate. I think if Winston Churchill was here today, he might say the current system of independent investment company directors is the worst form of corporate governance ever, except for every other method that has been suggested.

I think what you end up with in this system, given differences between theory and reality, is that independent directors are recognizing that the investors buy the adviser, not the directors. They are fully cognizant of the adviser's investment capabilities, the track record, the fees charged and that the director should not substitute their judgment for those of the investors as long as the adviser continues to provide the product that was chosen by the investor, that fees are not excessive and that the adviser is not in violation of the law. I think independent directors have been caught in a crossfire. The press talks a lot about their ineffective ability to cut down fees or to terminate poor performing advisers. The Commission jawbones. There are a lot of speeches asking independent directors to be the first line of defense and to take action. But yet the only enforcement actions against independent directors are for technical violations, not for failure to maintain low expenses or even for failure to terminate poor performing advisers. And maybe that's because independent directors shouldn't do those things. In fact, when the Act was put together in 1940, the Commission wasn't concerned with the level of fees at all. In fact, there were statements in the record that said that the marketplace should govern what the fees are and someone wants to pay someone 100 basis points, someone wants to pay someone 200 basis points, they should be able to do so. Based upon the PPI report in 1966 and I think the realization that directors can't negotiate fees as effectively as the Commission or others would like, the Commission considered adopting a reasonableness standard which didn't go forward. Finally, in 1970, Congress decided to impose the condition upon advisers under 36(b). My outline suggests a number of things that can be done, and I think a lot of those merit a lot of discussion and really in a public forum. The one thing though that we have now is a system that depends upon effective independent directors for whatever duties are imposed upon them. A crucial element, in my opinion, of having a strong independent director structure is having a strong regulator dedicated to the success of that structure. Let me throw out an example. Let me throw out a hypothetical. Suppose you had the president of an adviser who is also the president of the fund who allegedly used his powers and influence as fund president to secretly and then overtly pursue the interests of the adviser. Suppose first, without the knowledge of the independent directors, he used the fund's lawyers to draft a proxy statement to remove the independent directors.

Suppose he hired a proxy solicitation firm for the adviser and then, without the knowledge of the independent directors, used his office of the president of the fund to appoint the same firm as the fund's agent to receive fund shareholder voting lists. Third, suppose he used his office of the president without the knowledge of the independent directors to call a special meeting of stockholders so that the adviser could solicit proxies to remove the independent directors. Fourth, suppose he sent a letter to each of the independent directors announcing his actions, requesting their resignations and threatening them with personal financial ruin if they contested his actions or used the fund's assets to mount a counter solicitation. Suppose in this hypothetical all of those things happen and the directors, after regaining their composure, send an impassioned plea to the Commission that could be summarized in four letters, h-e-l-p. One might think that that would be a time when the Commission might take action. The Commission has broad 36(a) powers attributable to it and one might think that might be a time to use them rather than simply sit on the sidelines and refer to this as a corporate governance structure. I have heard an industry leader describe independent directors, the ideal independent directors, as management's best friend, the type of friend that will take the keys away when you've had too much to drink. If the Commission expects independent directors to be the first line of defense, then it has to support those directors who take the keys away. If it doesn't, it's equally responsible for allowing drunk drivers to stay on the road. Paul, let me go back to your question –

Mr. Smith: We started and ended with Navellier.

Ms. Peters: Tell him the facts he doesn't know.

Mr. Sturms: Paul, in that hypothetical, would that be a situation where the Commission would take action and, if not, why not?

Mr. McDonough: David, I carry a musing around in my head. I am not an expert, obviously, on Navellier but what would you think of a strategy where, given what I think the facts were, in any event, that an adviser is not forthcoming to independent trustees with respect to any matter. I want to see the profitability, I want to see this or that or whatever. And rather than going all the way and not getting it, going from that juncture to, okay, we're going to move the funds to somebody else's management company, you took the fees down by 50 percent at the first of the following month. Would that not get the attention of the adviser, number one? Number two, if he were to be so cavalier that he would continue to extract from the funds the previous higher fee, wouldn't that beget a phone call here to Fifth Street and get some action done pretty quickly? It looked to me like there were some steps that, frankly – I would never talk to our outside counsel about this, but those are the steps that I as an independent, chairman of the independent trustees, I would make it so difficult for that adviser, so onerous for him not to comply with – but even though he technically maybe – I couldn't successfully remove him, I could make his life pretty miserable and force him, ultimately, to do something that, by golly, would have the Chairman down his throat.

Mr. Sturms: Gerry, I think that's a good suggestion and, in fact, I think I have – in my practice, I have worked with independent directors that are incredible individuals, men and women that do the things that the Commission and others are asking. And I have seen again, over the last two days, a group of individuals which I think are the examples that the industry should put forward. I think what tarnishes this industry is the bad apples and the bad examples. And going back to the last panel where someone suggested that if there is an allegation by independent directors that there should be an immediate investigation, I think that makes sense. I guess I would take it a step further. I think the independent directors have been put in the position of being the cop on the street and been asked to do a lot of things. And I think if I were driving down the street and a police officer pulled me over for allegedly driving under the influence of alcohol and asked me to take a breathalyzer test and then I refused to take that breathalyzer test and then I punched the cop in the nose, even if I hadn't been drunk, I'm going to lose my driver's license and I'm going to go to jail. And I think in those extreme situations, the Commission needs to be prepared to take the type of action that a police force would take in terms of supporting their cops, their people on the street.

Mr. Smith: I can't resist pointing out in the Navellier situation the independent directors did resign. They were replaced by a new slate of independent directors, one of whom was president of a rubber stamp company.


Mr. Roye: I was going to wrap up this panel by asking each of the panelists to recommend one action that the Commission could seriously consider and that we ought to move ahead on in terms of improving the governance structure. I think I already have David's proposal. But for the rest of the panelists, if there's one thing that we could do or focus on that would make this all work better, what would it be?
Ms. Peters: It is difficult to answer that without focusing or targeting a specific problem. In these two days, we've been talking about enhancing the effectiveness of independent directors but, as David has pointed out, other than commentary from our esteemed press, who write articles about how ineffective they are, I don't know that the Commission has identified a significant or serious problem in the industry. But it is clear that an independent board will function better if the majority of the independent directors – if the majority of the board are independent directors. And that is one thing you can do on which you would probably have almost 100 percent agreement that it's the fact of life and you might as well conform the legislation to the practice.

Mr. McDonough: Paul, I think again, requiring a certain majority, 60, 66 percent, whatever it is, but certainly a clear majority of truly independent trustees with a very strict definition of independence, I don't know that I could be persuaded to ever let a former senior manager of a fund be designated independent. I don't care whether it's two years or 10 years. I just think that's fraught with risk for the shareholders. One other thing that I would love to see happen would be for someone to get the cost accountants, you know, in a room here and really wring out economies of scale. We hear more unsupported allegations about that. We hear about the tremendous, huge, vast growth in the assets and from that is supposed to come a dollar of cost reduction for every dollar and that just doesn't happen. And until people are willing to take the time to get into that subject to understand what happens when we now have 66 million individuals getting financial or account statements every month at 33 cents and printing them and postage and telephone, et cetera, et cetera, et cetera, the next person in this country who becomes a mutual fund shareholder has exactly the same cost per day, month and year as a 27-year shareholder of the same fund with respect to many of the costs. There will be a little bit less portfolio management fees. But if you take a look at where the growth of these assets have come, it has not been from the stock market alone. It is because we have had what used to be 3 million mutual fund shareholders. Now, 63 million more have joined them, and guess what? They brought money with them, which created $4.7 trillion. And those people don't constitute economies of scale, and therefore, I would like to make that whole subject go away, because that's another stick that the industry gets beaten with, which is not valid. What you need is some good, raw cost accountants out of some manufacturing plants, and they will show you what economies of scale are all about.

Mr. Haire: Paul, I made this recommendation when the Chairman wasn't here, but if I may briefly repeat it in his presence, what I suggested was that since the 1940 Act, which I think has worked outstandingly well for 60 years, was a cooperative effort between the SEC and the mutual fund industry, that perhaps at the millennium, it was time for the SEC to consider a cooperative effort with the ICI, which has moved into this area of director education, with counsel to the independent directors, many of whom have sat on these panels in the last two days, and with perhaps some independent directors who have had substantial experience in this subject to seek ways to assist those fund groups which do not have the resources to do all of these best practices that we've talked about here, in terms of establishing the independence of directors in carrying out their duties, to find ways to help those groups fulfill more effectively their fiduciary responsibilities, than they may be able to do, not because of any lack of desire to do it, but just because they can't hire high-powered independent counsel, and they can't reach out and do the things that we've talked about here. It may be a modest proposal, but I think at least it helps to build on what we have achieved here in the last two days, in terms of clarifying these issues.

Mr. Roye: Tom, did you have anything?

Mr. Smith: I would just endorse what I've heard said time and time again as this question has been asked to other panelists, and that is that the SEC and the staff be supportive of independent directors when they get into confrontations. And I guess from Yachtman, we are seeing that. I would point out, returning to Navellier just briefly, that I think the real problem there was when the first call came in and the question, and it was presented to the staff that they weren't receiving the information that was required by Section 15(c), it's my understanding that the response from the staff was that, well, the SEC staff doesn't have a position as to what is required by Section 15(c). I would submit that the courts have firmly established what is required – Gartenberg, Krisnk and so forth – what is required by Section 15(c). I do think that there are strong standards there. And hopefully the SEC can work with independent directors in seeing that they do get that type of information. I understand a little bit about what you were talking about originally, Paul, because we've been bashing the SEC and the staff on Navellier. I do know you were much more involved than any of us know, and I know it's just totally not a one-sided story.

Mr. Roye: Thank you. We've gone over our time. But I would just like to thank all of our panelists, the many panelists we had over the two days, the moderators who participated. Thank you for your participation. Before you leave, I wanted to give the Chairman the opportunity to give us some closing remarks. This was indeed at the Chairman's encouragement, to hold this roundtable, and I'd like to turn it over to him.


Closing Remarks
Chairman Levitt: I cannot tell you how enriched I feel as a result of sitting in on most of the past two days. I have listened quite closely, and I think I will make a personal commitment to everyone here to look very, very carefully in terms of what the Commission can do to empower those of you in the trenches. In many ways, I wish the clock could be turned back, but I think we learn from some of our past actions. That message comes across loud and clear. I also would say that I have been historically reluctant to seek legislative solutions, because those are so unpredictable, so hard to come by. I guess, fresh from my grilling by the Senate Banking Committee this morning, I'm even more reluctant.


Chairman Levitt: And I feel the same reluctance in terms of regulatory fixes. Having said that, I'm not sure that best practices is quite enough. I think there are certain salutary benefits that have been derived from this meeting and the attendant publicity. Certainly all of us will have something to think about. While I'm thinking about it, someone came up to me and said, "The answer to all of this is you've got to redo Section 2(a)(7)." I don't know what Section 2(a)(7) is.

Mr. Roye: The most complicated rule in the Act.
Chairman Levitt: I sure don't understand it, but I'm going to find out.


As I said earlier, this roundtable is the first step in the process, and sometimes the first step is the hardest, but I don't think it is, in this case. There were a number of really tough issues we discussed, and as we move forward, I think none of them should be taken from the table. But discussing is one thing, and action is another. Now, we need to take those next few harder steps. I'm asking Paul to begin an intensive, serious effort on behalf of the Commission to look at how we might help improve fund governance. I look forward to his recommendations, within the next 30 days.

Chairman Levitt: I hope and expect that those recommendations will culminate in far-ranging and concrete, specific proposals. But it would be unfortunate if those were the only footsteps of action that mutual fund investors hear. Given the leadership and insight represented over the last two days, I want to strongly urge the industry to undertake a similar effort in enhancing the role of independent directors, an effort that goes way beyond an articulation of best practices, an effort that reaches the level of meaningful change. I cannot leave these two days without reflecting once again on – and I think, Aulana, you will echo this – why it is such a special joy and privilege to be heading this remarkable agency, the people that put together this roundtable, the people whose names you are unlikely to hear, the unsung heroes of this event, the people that will make a difference, the people who are underpaid and overworked, and really make it so rewarding for all of us who bathe in their reflected glory. I look forward to working with all of you and hearing your views and contributions. I think we've gotten to know one another a little bit better, and I think we're all the better for the experience. So thank you so much for making the roundtable such a wonderful and worthwhile event.

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