Transcript of the Conference on the Role of
Independent Investment Company Directors
U.S. Securities and Exchange Commission, Washington, D.C.
February 23 & 24, 1999
Opening Remarks
Mr. Roye: I would like to welcome you to our second day of the directors' roundtable. I appreciate your being here. I recognize that the weather didn't cooperate with us this morning, but I think you're in for a treat today. We've got some interesting panels focusing on, again, key issues facing independent investment company directors. Let me remind you again that the press is present. Any remarks will be considered on the record. And we look forward to an interesting discussion. I'll turn it over to Barry.
Fund Disclosure and Communications
Mr. Barbash: Thank you, Paul. For those of you who may not remember, I used to be Barry Barbash. This morning, our panel will be discussing the role of independent directors in the effort to improve fund disclosure and communications to shareholders. Improving disclosure has been and undoubtedly will continue to be a central theme of the Commission's division of investment management's program. I am joined on the panel today by an experienced group of panelists with diverse backgrounds. Sitting immediately to my left is Norm Smith, a retired lieutenant general in the United States Marine Corps and an independent director of the John Hancock Funds. Seated next to Norm is Mickey Roth, who is the CEO of USAA Investment Management Company, one of the better known mutual fund companies in the United States. Seated next to Mickey is Don Dick, managing principal of Euro Capital Partners, a private equity investment and management advisory firm. Don is a long-time director of the T. Rowe Price funds. Seated next to Don is Bob Denham, a partner in the California-based firm of Munger, Tolles & Olson. He was formerly chairman and chief executive officer of Solomon, Inc. Bob is what I refer to as the panel's outside legal expert. He is not a practitioner in the investment management area. Some would say that's refreshing. But he is a quite well-known and respected expert in the securities law area. And then, seated next to Bob is Jay Baris, a partner in the New York City firm of Kramer, Levin, Naftalis & Frankel. Jay is the panel's inside legal expert. He's a specialist in the investment management area and is one of the more prolific writers of the investment management bar.
We are going to follow the format that was used generally yesterday. Each of the five panelists will give a short statement at the beginning, and then we will follow with questions and answers. I want to make a couple of preliminary observations. One is that we are following the principle of moderator immunity. There will be no attacks against the moderator in anything he did or didn't do in his previous life. I want to thank sincerely the two SEC staff people who had to put up with schedules that were evolving all the time, had to put up with my schedule. They had to come visit my offices at weird times to try to get me materials. And I want to thank Jennifer Choi and Heather Seidel. Jennifer won a lottery to be the person who manages this panel. I understand that they were lining up in the Division of Investment Management to see who could do this to me at the end of the panel. One other last observation, and perhaps the most important, is the one thing you can about this panel is that it is the tallest panel, and we are well positioned for the intramural basketball game that will be played after this.
(Laughter.)
Mr. Barbash: Except I was told that when we play against Willie Davis's team, I have to play one-on-one against him. With that, Norm, let me turn it over to you. Norm, I would note, we decided Norm should go first, because he had the highest rank.
(Laughter.)
General Smith: Well, thanks, Barry, and please keep the money coming. Good morning to you all, and Chairman Levitt, thanks for the invite to participate in this event. I came down here yesterday. I live nearby here, came here yesterday, just to see the flavor of what was going to be happening. I recognized at the discussions yesterday surrounding the regulations and the laws committed to the very underpinning of the mutual fund industry, it was quite apparent to me that the plain language initiative really is the star of the class. The very dramatic expansion of our mutual fund industry demands that we have plain language. Last night, returning to my home in the Blue Ridge, I got amused thinking about my friends and neighbors out 60 miles west of Washington. Had they been sitting in this discussion yesterday, and were asked them to give a resume of what they heard, I've got a hunch they would all be cheering for the plain and simple language initiative, as well. So our roundtable here, in my view, begs for this to get into being. As Barry mentioned, I'm on the John Hancock Mutual Funds' board of directors, independent. About five or six years ago, this initiative came to our floor. The independents, during a board meeting, were briefed about what John Hancock intended to do to work the plain language initiative into their prospectuses. They formed an organization reaching into all the various channels that make up John Hancock advisers, permanentized the organization so that the people knew they were going to be on this job, this challenge, for the entire time that they were with John Hancock, and got with it. They solicited a lot of fine input from the Securities & Exchange Commission, and the support received from them has been lauded.
The independent directors were periodically briefed as the project matured. We were given various drafts. We, the independent directors, were given various drafts as the project went along, and we made our inputs. The diversity on our own particular board, the various occupations that we have there, I think lent itself to working on this plain language challenge. At any rate, the drafts were often reviewed. Focus groups looked at them. Lawyers looked at them. Marketing looked at them. Advertising, and all the other various wire diagram blocks in John Hancock Mutual Funds looked at them to make sure that it was doing what we expected it to do. We found that it took real teamwork from the independent directors and the management, and the enthusiasm to get on with this particular project.
The independent directors agreed to accept some of the costs of this project, as well. We feel that that was money well spent toward developing it. The prospectus itself, for all you sharp-eyed folks, here's one example here: growth funds. And we wrote these prospectuses so that they encompassed all the funds that were in that particular style. For example, here, growth funds has some seven mutual funds in it. They worked very hard to make sure it was a large enough document that was easily read, the legend and the little icons in it are consistent throughout. The hiring of an outside writer was a great benefit – who was not a lawyer, by the way. We have received a considerable amount of accolades from shareholders, from the public in general. I think the SEC was fairly satisfied with the final product that came out of here. We had a couple complaints. One of them, one broker said that, in putting all of the mutual funds under one cover made it too difficult to sell a particular mutual fund because the clients were always shifting to another page and looking at it. Another broker grumped that the large-page, magazine-style size made it too hard to mail. Other than that, I haven't heard too much complaints about this particular product. At any rate, I can just emphasize that it takes teamwork to get the job done. Independent directors play an important role in it, as does the SEC. And I really laud the project to any of my independent director colleagues here in the audience. If you haven't embarked on this project, it is probably worthwhile getting after. Thank you, sir.
Mr. Barbash: Mickey, your organization also went through the process of developing an enhanced, better prospectus. Can you speak about that?
Mr. Roth: We certainly did. And I want to start off also by thanking Chairman Levitt for the invitation to be here. It is a pleasure to be here. It's also nice to follow General Smith. He's probably the only gentleman in the room who has been a member of USAA longer than I have. It was about three years ago, I was in Washington at a dinner in conjunction with the ICI annual meeting, where I sat next to Nancy Smith, and she mentioned that the SEC was going to begin working on a plain English prospectus. I immediately volunteered our help with that. This is something that was very close to our hearts at USAA. The fund industry has had a remarkable history in about the last 10 or 15 years, coming from far nowhere among financial intermediaries to become the premier way that Americans invest and save. There's a great trust there. The basic form of mutual funds is a good form. Unlike other intermediaries who, in the time that I've been in this business, have gathered great amounts of assets under management and then practically disappeared, the fund industry has one structural advantage and beauty to it. And that is, every day, as best we can, we tell you exactly what it's worth, and we provide great liquidity and we provide great service. A great trust has grown up with the American people, and people in other parts of the world, too, toward the fund industry. And it is essential, those lessons of other intermediaries that have come and gone tell us that we need to be careful, and we need to nurture that trust, and this plain English effort is a major way that we can do that.
As General Smith mentioned, the neighbors in Virginia, our folks who are USAA members are not always tremendously sophisticated or knowledgeable about financial instruments, and they need to be given as good a grounding as we can in just what it is they're buying and what they can expect from the financial product that they've purchased. When we set about to construct our plain English prospectus, first of all, we used our own people. And this was an effort among our marketing people, our legal people, our compliance people, and others in our organization. They worked very closely with Nancy Smith and her group, made a number of trips to Washington, and produced a product which we are very, very pleased with. In our case, because it was our own people who were already associated with our company and with our funds, the incremental expense to our funds of this effort was minimal.
An important point about the plain English prospectus, and about the only discouraging words that I've heard about it were concerns by, by some of my colleagues in the fund industry about the possible loss of protection for the companies, the liability question, that could occur by departing from time-tested, albeit stilted, language that has stood the tests of court. The thing that we found is that, with the inclusion of all parts of our company, the legal and compliance especially, that we could write a document that was complete, that covered, we believe, all the subjects that had to be covered. One of the things we learned is that plain English does not mean shorter. In fact, our plain English prospectuses are longer than our previous prospectuses. But, as in the case of John Hancock, as General Smith pointed out, for the first time in my 20 years at USAA, we received letters and calls from people who said that they enjoyed the prospectus.
(Laughter.)
Mr. Roth: In my previous experience, that had never happened. We are very pleased with the document. We're very comfortable with it. We continue to work on it, and it's something that we look forward to continuing.
Mr. Barbash: Don?
Mr. Dick: Thanks, Barry. Good morning all. In the couple of minutes that I have this morning, I would like to discuss the topic of disclosure and communication using a relatively wide-angle lens, and attempt to place it within the context of today's independent directors' duties and priorities. In the 19 years I've been a fund director, the business has changed from a small industry to what Chairman Levitt has termed a cornerstone of American investment. This change has manifested itself in several important ways that should be known to all of us in this room. However, my view is that, notwithstanding this broad industry change, directors' primary responsibilities will continue to evolve from the core responsibilities originally intended in the Investment Companies Act, however significantly they may be expanding in scope and complexity and however more important the requirement for a more informed director. Updated for today, I would like to define them broadly as setting the terms of the relationship between the adviser sponsor on the one hand, and the funds and its shareholders on the other, and assessing the ongoing capability of the adviser sponsor to carry out its mission. The areas of our specific focus should include investment performance, availability and quality of service, availability and quality of communications, the cost- effectiveness of each and all of these, and the ongoing ability of the sponsor to provide the services. The proper context in which I believe directors should evaluate matters of disclosure is within that focus area that I've called the availability and quality of communications. Matters that fit properly within this area include traditional disclosure matters, such as fund strategy, continuity of management, historical performance, risk, and expenses.
In addition, they may include service and communication capabilities, the array of growing information and communication techniques available to the shareholder, general market advisory information, and matters involving the sponsor, that impact the funds directly. Given the number of funds and the proliferation of strategies in the evolving shareholder mix, and so forth, it is appropriate and even necessary that the industry address the issue of quality and simplification of its communications on a continuing basis. Plain English, on profiles, individual fund initiatives, two of which we have heard about here this morning, are certainly necessary and very constructive steps, in what should be an ongoing industry process. In conclusion, I would like to put a couple of cautionary notes to that process. First, like so many things in our wonderful system, a not so wonderful thing, litigation, also follows the money. Initiatives to simplify and clarify must, therefore, somehow always mesh with the need to provide adequate disclosure, particularly with regard to matters that may involve material risk. Second, the line between what should be required disclosure and what is simply useful is sometimes blurred, and is always shifting. However, wherever and whenever possible, communications and disclosure should be market driven, and not regulation imposed. In this regard, the industry's best interests will be served by its regulators continuing to seek open and frank dialogue in the pursuit of new solutions and directions, and using the bully pulpit, before the word processor. Thank you.
Mr. Barbash: Bob?
Mr. Denham: Chairman Levitt, thank you for this opportunity to participate in the conference. America is blessed with a strong competitive and diverse mutual fund industry. How well this industry serves investors depends critically on the ability of investors to make rational choices among the rich diversity of funds that are available to them. This ability in turn is critically effected by the quality of disclosure because disclosure involves conflicts between the adviser's interest in maximizing profits and the investor's interest in being able to make the best choices. Directors, particularly independent directors, have a critical role to play in the disclosure process. When we talk about disclosure I think there's a temptation, perhaps partly lawyer-driven, to focus on the prospectus. The prospectus, of course, is the basic disclosure document. But as a practical matter, to the extent investors look at anything they're more likely to look at profiles, and I think increasingly the profiles that they access on the web, than to look at the prospectus. So directors should pay attention to those profiles in the same way they pay attention to the prospectus. In looking at how to improve disclosure I take a fairly simply approach. I think about what I would want to see as an investor in being able to improve my ability to make choices. There are two areas that matter, one is performance and one is the investment approach of the adviser. The first one is relatively easy to talk about because performance can mostly be expressed numerically.
Funds in America do a particularly good job particularly when you compare them with most of the rest of the world in following a standardized format, a fairly standardized format, for giving performance data. There is, however, one very big hole in the US performance disclosure scheme, and that is disclosure of tax-effected data. For many funds the tax-effected data are not – are not that relevant for some funds but for actively managed growth funds tax-effected data is necessary for investors to make a rational choice if they are investing with taxable funds. The objection has often been made that it's hard to give this kind of data because every investor has a different tax situation. That simply makes it a little bit more complicated but not very complicated. One can provide tax- adjusted performance data at a zero percent rate covering probably about two thirds of accounts that are non-taxable money. A 25 percent rate, a 35 percent rate, and a 45 percent rate and then it's pretty – and then either you have a rate that's quite close to yours on the table or by simple interpolation you can get pretty close to what the performance would be for someone at your rate. A second area where I think performance data can be improved is with respect to risk because performance – good performance – what we're really looking for is obtaining the best performance at moderate levels of risk. If you can maximize performance and do so by taking a little bit less risk than another fund with similar performance you would like to choose the fund with the best performance and the lower risk.
Disclosure of risk data is complex – is somewhat complex to explain to investors. That's where the role of intermediaries come in who can take the data that funds disclose and interpret that in ways that investors can better use. Many funds – I went this weekend in preparation for this I went on the Internet to look at web sites of some funds. Many funds are giving very good risk data and giving pretty good explanations of it. I think funds that – for which their risk profile is a competitive advantage ought to look at that disclosure as a way of getting competitive benefit.
A third area relative to performance that I would pay attention to is how much money is managed by the same manager in the same basic style? That's not easy information to get currently. You can probably get it but you have to hunt around to put all that together. Moving from performance to investment approach. Investment approach involves more subjective judgments but it's something that I would want to know as much about as possible in choosing a fund manager. Ideally I'd want to hear in the manager's own voice what their investment style is. When I was at Solomon and chose a fund – I had to choose a fund for my 401-K I was able without reading the prospectus simply to pick the fund manager – the fund who was managed by the manager who had – whose approach to investment was the most rational in my view, that was because I knew who the managers were and talked to them. Investors aren't normally going to have that. But if investors have seen a disclosure in the manager's own voice of their approach to investment that is the best way to get a fix on the investment style and the investment approach. Plain English is a very important initiative of the Commission because it contributes to the availability of investors to understand investment approach as the manager would explain it. But there's a hazard involved in plain English and it's not the hazard that lawyer's usually talk about, it's not the liability hazard. It's the hazard that plain English will mask muddled thinking. If the investment manager has an unclear view about the way they're going to approach hedging or an unclear view about duration management in a bond fund I would much rather that come through in the description than to be hidden by a good copywriter's interpretation as put down on paper. Here I think the Board can play an important role in understanding what the manager's approach to investing is and in ensuring that that approach as set down on paper in plain English is accurate.
Mr. Baris: Good morning, Chairman Levitt. Good morning, colleagues. I'm going to spend a few minutes talking about an issue that's on the minds of mutual fund directors, simply will the new push for plain English create more liability for funds and fund directors? The answer I believe depends on whom you ask. Let's look at plain English for a moment. What is plain English? It means writing clearly so that ordinary people can understand difficult concepts. It doesn't mean dumbing down, making short, leaving out important information. It also means re-tooling America's lawyers so they can write understandable prospectuses. This is a big task. Why should directors be concerned about plain English? Well, the old kitchen sink approach offered some measure of comfort throw in everything but the kitchen sink and there is some protection against the law but at least that's the belief. The new disclosure rules require funds to disclose principle investment strategies, principle risks of investing. The funds must summarize these ideas in an easy to understand way. But how can you easily summarize certain concepts like partially protected commodity-linked notes? The big fear, of course, is will something get lost in the translation? This all leads, I believe, to conflict, real or perceived, between the need to disclose enough information and the risk of creating more liability for funds and their directors. Recent litigation shows that plaintiffs aren't bashful about claiming that prospectuses omitted important information and nobody really knows what's going to happen in the courts. There aren't any cases we're aware of that address the liability issues in the context of plain English. Some say that plain English does not result in more liability for funds and their directors. The SEC has argued that plain English does not meet omitting important information and, therefore, no additional safe harbor is appropriate or necessary.
Now that you have the statement of additional information, which is the new garbage dump for detailed information, this is all incorporated by reference. There is some measure of protection there. Of course, you have provisions in the Federal Security laws that say if you in good faith rely on the regulations you should have some protection. But there are others that are concerned about increasing liability. What is a principle investment risk or strategy in the eyes of – is in the eyes of the beholder and it's often with the benefit of hindsight. The courts and plaintiffs' lawyers, of course, are not bound by the opinions of the Commission and its adopting releases. Again, there aren't any known cases that come under plain English. There's a flip side here, too. Will funds and their directors be liable for failing to write in plain English? Will this give rise to the creation of the grammar police? Will we see prosecution for new offenses such as statutory verbosity, intentional infliction of pecuniary distress, felonious use of a double negative with intent to confuse, and most heinous, the involuntary run-on sentence? Seriously, this gives rise to some questions. The questions of the day are what can directors do to reduce their liability? What can and what should the Commission do? Is it necessary or appropriate at this time to consider other avenues such as litigation reform?
Mr. Barbash: Thanks to all of you. The statements raise a number of interesting themes. I want to come back and start to look a little bit more closely at some of them. My first question I wanted to direct to Norm and to Mickey. Your organization is – or the organizations with which you are affiliated have made re-tooling prospectuses a high priority. With the power of 20/20 hindsight at this point a year or two years after are you still convinced that it was an initiative that should have been priority? Have the results been favorable enough to support what you did?
Mr. Smith: I think it's probably difficult to answer that question or measure the success of simplified prospectuses from an industry-wide – mutual fund industry- wide but as far as John Hancock goes we received considerably good press from it. Good comments from the shareholders and brokers. Good comments from peers in the industry. Good comments from the focus groups, where they took the Hancock simplified prospectus and compared it against competitors' prospectuses that had not gone through the revision procedures. So I think from, as a whole I would say that it was well worth our effort within John Hancock to do this. I think ultimately it will prove very beneficial to our shareholders as an education tool, as a guidance tool, as a training tool. These sorts of things I think is incumbent upon the leadership in the mutual fund industry to grab a hold of and make it all work. So, yes, Barry. Long-winded but, yes, it was well worth the effort.
Mr. Roth: We would certainly feel the same way. We are a no load fund group. We market directly so we don't have brokers as intermediaries. We felt from the beginning that this was a very important step to take in communicating more clearly and more effectively with our shareholders and we think that we've done that. We feel very good about this. Our focus groups were quite enthusiastic about it, as I mentioned in my opening comments. We have actually received comments back from shareholders that they enjoy this and that's never happened before. As far as a question of how this plays in the industry, would it give us an advantage? I don't think so. I think that this is going to be very quickly a level playing field because I think there are just obvious and compelling arguments and reasons to go to this kind of communication of the basics of mutual fund investing with your shareholders that it will become universal.
Mr. Barbash: When Bob was giving his statement he suggested at one point that there's an awful lot of information out there about mutual funds. You can get on a web site, you can go to most major financial publications, you can go to newspapers. There's a lot of information about it. Why do we need the prospectus if we have all that kind of information out there? From your perspective you've made – your organizations have made an attempt to make the prospectus worthwhile but why? What does it do for you relative to those other sources of information?
Mr. Roth: I'll take a first shot at that. The prospectus is the user's manual and it is unceasingly important to try to get across to shareholders exactly what it is that they're buying, to have them understand the true nature of the investment, hopefully the relationship between risk and reward. Some of the comments Bob was talking about are very, very interesting ideas. Difficult to get across but extremely valuable. The head of our sales and service organization talks at times about not infrequent conversations that our reps will have with people who will call up and say, "I want some of the 40 percent fund." They don't know the name. They don't know what it's like. They don't know how it's composed. They just know that they saw in the newspaper or magazine that one of the funds was up 40 percent and that's what they want and that's, frankly, dangerous.
Mr.Baris: I would just add to that the amount of available information, of course, is uneven and it's a sad reality but people are buying shares on the basis of information that may be good or may not be complete. But, more importantly, no matter how the investor is buying the shares it's the fund and the directors and the officers that are liable for what's contained in the prospectus which, of course, is required by law. So even though somebody is buying off an ad they can still find or allege a deficiency in the statement of additional information concerning something say, oh, I don't know, involving derivatives and plead a case and have a day in court.
Mr. Barbash: Norman, in your discussion you talked about the issue of cost. You thought that it was significant to improving of the John Hancock Fund prospectuses that the funds incurred some of the cost of going forward. There's a lot of talk these days about mutual fund expenses and mutual fund expenses going up. How do you square paying out more money? Do you think it would be a worthwhile exercise for fund directors to look at the cost of improving prospectuses? Should a Board say, "Look, it's just too expensive? We're going to leave it as it is? We're going to – we'll comply with SEC rules but at the minimum it just costs too much?"
Mr. Smith: Well, Barry, there's probably somebody in this room that could answer that question better than I can. Chairman Levitt can answer that question. He's the one that's been really talking of this and I applaud him for that. So, yes, the cost benefits are worth it. We've found that it wasn't as difficult to review these prospectuses. You save time and money on the legal review of them. The old hackney term "Economy of scale," we did receive that. It didn't take so many cover sheets in our organization to send out – to cover all the prospectuses that talked to the various funds by type. Again, as I mentioned before, this education tool to our users, to our shareholders. I can't emphasize that enough. Mutual funds play such an unbelievable part in the American economy today in the savings and our families that it's important that the average shareholder can sit down and pick up a piece of paper and – and with illustrations, with examples, understand what they're getting into with their savings. I think that's a very laudable act for all the mutual fund industry to get involved in.
Mr. Barbash: What about the issue of director involvement in prospectus rewriting? I've talked to people in the industry who say we've worked hard to try to integrate our directors in the process of revising disclosure documents. But it doesn't work very well. I'd ask Norm and I would ask Don, as independent directors, what do you view the role as the director in the disclosure process. Obviously I would think neither of you think it's simply to sign off on the registration statement. But what is it? What is your role?
Mr. Dick: I would put that in the context of how I view the overall director's role. The first instance, I think it's overseeing an orderly process that governs the relationship between the fund and the shareholders. And I think what happens in that overall process is that a good board can bring a substantial amount of business judgment to seeing that process works on an effective, high quality basis to deliver the product. The product to me is basically in its – at its root, an investment product. That sort of core has grown to be an investment product with a very high service element around it, and has further, is further rapidly evolving to be an investment product with a high service element with a very high cost component around it. And all of those things, I think, require and demand – both on the management and the directors – a high level of independent judgment. It seems to me that communications in general are an important topic within that mix. But when one gets down to the prospectus, which is what I understood you asked, Barry, it seems me that that is basically a tool that's a combination of a regulatory tool to make sure that certain specific bases are touched on the one hand, and a marketing tool which allows the firm as part of a total marketing mix to put forth its particular product. Therefore in that instance it seems to me that that particular role is in the primary instance a role between the sponsor and the regulators. And that while there is certainly an oversight role, it's within the context of what I view the larger mission as being. And I guess, to summarize it succinctly, I think we will more effectively have accomplished what we're all about if we do a thoughtful job of understanding and dividing the benefits of economies of scale than we will opining on a prospectus.
Mr. Barbash: Don, you've won the prize for piquing the interest of the Chairman. I think he had a question for you.
Mr. Dick: Uh-oh.
Chairman Levitt: It's not a question, it's an observation, perhaps. And, first let me say, in general I think you're right on. You're instincts are good and sound. I think your company has been a pioneer. And it's that spirit that I would like to see. I would like to see restless, passionate directors. Directors who cared so much about the well being of investors that they ask the tough questions that many times corporate management find difficulty with. If we could harness some of the skills and creativity that go into marketing the funds in terms of how we can get across basic information to the vast majority of the public that simply don't understand what they're buying, what the risk may be, what the attitude of management may be, if you could in some way or other communicate to the investing public that Manager Smith, who has been sold in ads and direct mail for four years, has left. And now Manager Jones has come on board. And how do their investment objectives change. And I would like you to ask the question whether it's relevant to more frequently outline portfolio changes, changes in strategy. Sure, I'm mindful of the risks of liability and litigation, very mindful of them, having been personally sued any number of times. But with the amount of money from unsophisticated investors never having seen a down market out there, I think the need for greater disclosure, clearer disclosure, more controversial disclosure is just greater than ever.
Mr. Barbash: Don, let me ask you a follow-up question. In terms of the role of the independent director, you've been a mutual fund director for close to 20 years. What's the biggest difference that you see in the role of the director, say, from the 1980s to the 1990s?
Mr. Dick: In my view, Barry, that's a direct outgrowth of what's happened to the industry as a whole. The industry as a whole, it's rather obvious it was sort of at the margin of the investors' thought process at the point that I first came on aboard. Today, it is truly, I think unquestionably, certainly a corner stone product. That has obvious implications for all the things that these panels are discussing. Certainly, it affects the scope of each of the things that we were originally charged with doing in the 40s Act. Some of the things that I would mention here which maybe are not so obvious on a day-to-day basis, but pretty clearly come into my view of things, and that is that an independent director needs to have a very broad sense today of what's going on overall in the investment climate, what changes, what trends, et cetera are happening out there. Because really while one sits on a fund board – a legal entity – in most instances we sit reviewing a family of funds, and we need to put that in the context. So that's certainly one major change that I've seen – participation in maybe one or two kind of corporate activities, to participation in a fund. I think the next implication of that to me is that sort of matters of policy and strategic substance become playing a larger role than those of sort of procedural activities which pretty much dominated life 20 years. Another, I think major change is that we now are responsible for contracts – not only investment management – but contracts in the service area that as an industry must be generating billions and billions of dollars of revenue for the sponsors. That clearly is a different change from what existed 20 years ago. I could go on, but I think there are a few things that in my mind are pretty dramatic shifts.
Mr. Barbash: It strikes me that a premise of trying to get good disclosure about a fund is that those who oversee the process have to have an understanding of what the fund does. That's a fundamental step. If you're going to make sure that you have a document that describes what the fund is, people have to understand. Does that – and some of the things that you were talking about, Don – does that imply that we ought to think collectively of having standards for independent directors? In other words, should independent directors have to have some kind of background in the financial world?
Mr. Dick: I guess, my view comes back to what I said a little earlier. I think the overall role is really one of oversight of an effective process of bringing the investor to an investment product on which they're relying. Therefore, I think in that context the most important attribute a director needs to have is the ability to make the kind of business policy judgments that can assure that that process is as effective and efficient as it can possibly be. In that context, I think the board itself, therefore, ought to have a blend of backgrounds and skills and experience that can contribute – that can create a mix that contributes to that overall desired result.
Mr. Barbash: So your answer would be not individually, but it would be a good idea of the board as a whole had some kind of –
Mr. Dick: Better feel.
Mr. Barbash: Norm, do you have a view on that?
Mr. Smith: Obviously, my career didn't establish my position as an independent director anywhere. I believe that a successful person in a tough career can bring honor and integrity into that particular position. I believe the director ought to have a sensitivity for those for whom he is representing, and that's the individual shareholders. I try to stick pretty much myself on the John Hancock Board to the blue-collar shareholder. And I guess that comes from 36 years of leading Marines into harms way on occasion. You look out after the people that you're getting paid pretty dog gone good money to look out for. And I feel it's important that we do that in that particular manner and never lose sight of that. This is why I made my opening my comments – I sat in the back of the room yesterday and listened to this unbelievable dialogue that was the underpinning and the foundation of our industry and I got to thinking what would the Joe blue-collar come in here and think about in this particular case. And he'd have a tough time wading through it. And that's why I also think that USAA and Hancock's piece of paper that simplifies, educates, lay out, builds the credibility of the organization has something to do positively. And I can't sit on our board and make great financial disclosures and all this sort of thing because I haven't got that background. I'm learning. I work at it. I try. But somebody has to keep an eye on the great masses out there that are investing in our very lucrative business.
Mr. Barbash: I'd say amen to that.
Mr. Dick: Okay.
(Laughter.)
Mr. Denham: I think fundamentally what we ought to be looking for in independent directors of mutual funds is people who think like investors and who when the occasion requires it are willing and able to stand up for what they believe in. Unfortunately, a wealth of financial experience sometimes is a contra indication for thinking like an investor. And I would suspect General Smith does a darn good job thinking like an investor and is perfectly able to stand up.
Mr. Barbash: Jay, do you have a comment? Bob, let me stay with you. You suggest that a next frontier in mutual fund disclosure is tax-adjusted return information. And I think many would agree. In one of today's papers there is a story about the mutual fund business which suggests that one of the issues that the fund business has to tackle is just that, that an inability to deal with that issue is going to cause the fund business to lose some its luster. There's also a major-league sized ad in the paper today by one of the largest fund groups about a new tax efficient type of fund. So it seems as if it is an issue that a lot of people are focusing on. And I can tell just from my own experience as Division director was an issue that we focused on. But what would you view the role of the independent director to be in connection with that kind of an issue?
Mr. Denham: I think it would be a very good thing if directors would insist on tax-adjusted disclosure performance for funds where that's relevant. Unfortunately we've have 59 years of experience under the Investment Company Act, and for the most part that hasn't happened yet. So I think this is an appropriate area for the SEC to require tax-adjusted performance results to be disclosed.
Mr. Barbash: Mickey, any thoughts about tax- adjusted performance as a next frontier? Or any other areas where you think disclosure might be necessary or appropriate?
Mr. Roth: Tax-adjusted performance is a very interesting topic, one that we've been very interested in for a long time. We have one of the oldest tax efficient – if I can use that phrase – funds out there – USAA Growth and Tax Strategy Fund. It's an interesting fund. It's approximately 50 percent common stocks, 50 percent tax-exempt bonds. In order to pass along the tax-exempt interest the tax-exempt bonds must constitute more than 50 percent of the fund. It has given us some interesting insight into this question. It is ranked by mutual fund rankers with balanced funds. But obviously it's quite different. By necessity its percentage in common stocks is lower than your typical balanced fund. And in the past few years especially that has been a great detriment to it. And then obviously it's bond portfolio is producing tax-exempt interest and the raw yield is lower than any other balanced funds bond portfolio yield. That's strike two. The performance figures are never adjusted by anyone who presents performance and so – and therefore the fund usually lingers around, interestingly the mid point of these funds and has never been in those comparisons a stellar performer. Years ago I remember our marketing people came and said to me, we can't sell this thing. And yet for as long as we've had it, month after month there are net sales of this fund. And it points out all parts of it. There is a hunger for this. There is a realization out there that there is something strange about the tax treatment that mutual funds must give to the actions which they take. But yet it is nowhere near being highlighted in the typical measures of funds. Maybe the ultimate comment on this is I spoke about this with a reporter about a year ago. And we have tried to promote this idea of tax-efficient investing and the after- tax return. And his comment to me was, who cares? That's his view from his readers. So there is an opportunity out there and, frankly, I intend to have our company keep hammering away at it. That particular fund has a very nice, long-term tax record. And if we ever do – which we do once in a while – find a publishing of tax-adjusted returns it leaps way up. But it's a complex topic and one that is difficult for the average investor to grasp.
Mr. Barbash: Mickey, one quick follow-up question and then I want to turn to the infamous L-word. What about the argument that tax-adjusted returns is not all that important to many in the mutual fund business who invest their tax-exempt vehicles? Is that enough of a reason not to make it a priority?
Mr. Roth: I think Bob touched on that very interestingly when he said that it would be easy enough to go through the range of possible tax situations. And obviously one of them is zero. When we look at the USAA Income Fund, goodness, I think that about 80 percent of our accounts in that fund are in IRAs or other tax-sheltered vehicles. And, obviously, if we were to produce a tax-adjusted statement for it, the income fund would be greatly affected. So I think it forms part of a viable spectrum.
Mr. Barbash: Let's finish out the time by talking about liability. Jay, you raised that in your discussion. Do you find that independent directors regularly ask you the question, if I do this – or if I take that action, will I be sued? Do you find that it's first and foremost on directors' minds?
Mr. Baris: Yes.
Mr. Barbash: What about the directors? Do you – both of you intimated in what you were talking that it is an issue?
Mr. Dick: I mean, it's obviously an issue that should be dealt with in the context of where one heads. I think at the end of the day there needs to be enough appropriate disclosure that the investor can make a very informed judgment about where are the – particularly where are the material risks in this particular activity. I think that's the one that most concerns me out of the mix of possible areas of litigation.
Mr. Baris: We get asked routinely at board meetings – we're put on the spot – will this – is this okay? And they're asking the lawyers to make a legal judgment, which, of course, is appropriate. But what it really comes down to – and sometimes the appropriate answer is – are the directors asking the right questions? Are they overseeing in an appropriate way to ensure that the process is in place so that their business judgment is being exercised?
Mr. Barbash: Picking up, Jay, on some remarks in your statement, do you think that the SEC is supportive enough of liability concerns? Does the Commission pay enough attention to liability concerns?
Mr. Baris: Well, I think that the Commission is obviously concerned about it. As Chairman Levitt mentioned earlier, he's very well aware of the liability concerns. But reasonable people can differ as to how far and how active the Commission could be in reducing liability. And I don't think there's an easy answer, but I do think there are other things that the Commission could consider. The Commission considered and rejected a separate safe harbor for liability under the plain English rules. And I think that's something that remains to be seen. And it's something I think the Commission should reconsider.
Mr. Barbash: Bob, do you have any views on liability safe harbors?
Mr. Denham: I don't see a compelling argument for liability safe – I guess, I don't see a compelling argument for liability safe harbors in connection with plain English disclosure. I think plain English if it's done well, helps a firm avoid liability. Because if it's done well, it forces you not only to a plain explanation of what you're doing but to thinking out in a clear way what it is you're doing. And I think that the liability issues often come out of – you know, the case has to be expressed as a disclosure case. But underlying the disclosure case, there's usually a real muddle about what how the funds' management thinks about the way its investing. And that's the muddle that needs to be exposed as you do in plain English prospectus.
Mr. Barbash: I was going to ask a question which I think you just gave the answer to, what in your judgment – and I would ask this to Jay, as well – what in your judgment provides the greatest protection against liability? It sounds, Bob, as if your answer is if you're clear about what you're investing in and there's clear communication from the fund managers to the lawyers to the directors, you will get a product that will describe it well and you'll minimize liability that way. Is that fair?
Mr. Denham: Absolutely, investors have a lot of choices to make among mutual funds. And one of the best roles directors can play is to help assure that the description of the choice that is offered by a particular fund is an accurate description so that the investor can make a reasonable choice.
Mr. Barbash: Jay?
Mr. Baris: Yeah, and I agree completely with what –
Commissioner Unger: Excuse me. When you're talking about liability – and I apologize if you already specifically laid out what areas of liability you're concerned about, but what exactly are you most concerned about in the area of liability?
Mr. Barbash: Generally, here the focus has been on prospectus liability. So we're talking about the role of lawyers, management and others in drafting a document that might be shorter, in plain English. And it may or may not be shorter. But the question is whether there's greater liability potential coming out of disclosure principally, although the question is really posed beyond – beyond disclosure.
Mr. Baris: Just to follow up, I agree with what Bob said. And I think that what is critical is getting the portfolio managers involved in the process to make sure that what they're doing is accurately disclosed in an easy to understand way. And that's something that the directors can ask management: are the portfolio managers involved, and to what extent? And carrying that one step further, the record should reflect, the minutes of the meetings should reflect that these questions have been asked. And I think that would go a long way to reducing liability.
Mr. Barbash: Let me conclude by asking each one of the panelists a question. I know this is going to take the panel over our allotted time, but, you know what, it's not the first. And it's not the last time with me.
(Laughter.)
Mr. Barbash: If you could ask the SEC to do one thing that would greatly aid fund independent directors in carrying out their responsibilities what would the one thing be? Norm, let's start just going straight down.
Mr. Smith: Well, I guess it would be to participate in any litigation at the earliest possible stages when a fund's use of plain language is being contested. And if you dig into my statement, you'll find that's the last thing at the bottom of the page 2. Thanks.
Mr. Barbash: Mickey?
Mr. Roth: It's an interesting question to try to answer what would I want the SEC to do for us. The key thing here I think – in my opening statement I talked about the great trust that has grown up, that has propelled the mutual fund industry to become the premier financial intermediary for the American people. And I think what the Commission can do, number one, priority is to do things to preserve that trust, to make sure that it continues to impel us toward things that work toward the benefit of the investors, to foster their understanding, and a great example is this plain English initiative.
Mr. Dick: If I understand I think the Commission's thrust in the last couple of years it is to challenge directors to be more actively involved in what I would term are matters of substance, matters of policy, matters of strategy. And I think that is very positive. I think what I ought to ask the SEC in that context would be to work with the industry to look at the overwhelming stack of paper that we get which I would call matters of procedure to see if there isn't a substantial amount of that – or at least some of it – that could be handled in some other way, and therefore free the total activity to be more strategic and substance-based.
Mr. Denham: I would encourage the Commission to look for opportunities to highlight best practice. It's the very important job of the Enforcement Division to highlight worst practice. And that necessarily has to be part of what investment management does. But the Commission should look for opportunities, and I think that's the spirit in which this conference is being done, frankly, to highlight best practice among firms and to be able to point to ways in which funds are providing more disclosure than is required, clearer disclosure than is required, more accessible through the use of very well designed Web sites, for example, more accessible disclosure than is required. And I think that's maybe the best service the Commission could render.
Mr. Baris: I would say there are two things. Number one, keep doing what you're doing. I think that the plain English initiative is very successful and will have long-term benefits that will be very, very good. And the second thing is – which you will find on the bottom of page 5 of my presentation – is stand up for the directors. If there is a lawsuit in this area, I would urge the Commission to consider filing a friend of the court brief, too.
Chairman Levitt: On behalf of the Commission, I would say that these recommendations are all really sound ones that we would embrace. And I think that all of you are a great example of the kinds of people who should be squiring the boards of investment companies and we're very lucky to have you make this commitment, thank you.
Mr. Barbash: I would note that we have a bunch of questions which we didn't get to. And feel free to ask anybody on the panel about the answers – come up afterwards. I would note that Jay's and my rates are a lot higher than Paul Roye's at this point. So you may want to pose the questions to him. Thank you very much.
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Role of Directors in Acquisitions of Investment Advisers and Reorganization of Funds
Mr. Roye: Our next panel is on the role of directors in connection with acquisitions of advisers, changes in control situations, and reorganizations of funds. As I'm sure you know, there has been a fair amount of consolidation in the mutual fund industry and in the financial services industry, generally. In the division, in the last year, we probably saw an exemptive application once every couple of weeks, raising merger, change, of control issues, and we're trying to do something about that by amending our rules to eliminate the requirement for some of this exemptive relief. But it's a trend that's here. It will continue. It raises unique and special issues for independent directors.
I think we're privileged today to have another distinguished panel to discuss this very important topic. To my immediate left is Rachel Robbins. She's the general counsel and managing director of JP Morgan and Company, Inc. and of JP Morgan Securities, the US securities subsidiary of JP Morgan and Company, Incorporated. She heads up the legal department and serves as chairman of the board of the American Bankers Association Securities Committee and is a member of the SIA Federal Regulation Committee. Next to Rachel is Dr. Joseph Hankin. Joe is the president of Westchester Community College and a full professor at Teachers' College, Columbia University. He holds Doctor of Education degrees in both history and administration of higher education from Columbia University. He serves as president of the Middle States Associations of Colleges and Schools, and is an independent director of the Stagecoach Funds and the First Choice Funds. Next to Joe is Dawn-Marie Driscoll. She is an executive fellow on an advisory board at the Center of Business Ethics at Bentley College. She is president of Driscoll Associates, a consulting firm. She was formerly vice president of corporate affairs and general counsel of the Filene's Department Store chain, formerly a partner at the Boston law firm of Palmer and Dodge. She is an independent director of several Scudder Kemper mutual funds, a member of the Board of Governors of the Investment Company Institute, and chairs its Directors Committee. She has also published several books and articles in the area of business ethics and is generally regarded as an expert in that area. Next to Dawn-Marie is Dave Butowsky, who is one of the deans of the '40 Act Bar. He is the main partner in the New York law firm of Gordon Altman and Butowsky. Prior to entering private practice, Dave was on the staff of the SEC and was the chief enforcement attorney in the predecessor to the Division of Investment Management, responsible for the SEC's nationwide inspection program for investment companies and advisers and responsible for the Commission's enforcement effort.
What we would like to do this morning is start off with Dave, to sort of lay out the legal framework for us that director's operate in when they consider changes in control type situations, and then we'll turn over the discussion to Dawn- Marie and Joe, both of whom have been through several changes in control in connection with their mutual fund director responsibilities. Then we'll go to Rachel, who will give us a perspective of the acquiring firm in those kinds of situations, and touch on some of the issues raised by the global aspect of consolidation in the industry. Dave.
Mr. Butowsky: Thank you very much, and good morning to everybody. I've been asked to, as you just heard, set out the legal framework of independent director responsibilities in connection with acquisitions and reorganizations. I've been asked to do that in 10 minutes, but Barry Barbash has told me I can have an additional 10 minutes.
(Laughter.)
Mr. Butowsky: First let me tell you that my written materials set that out much better and in more detail than I could possibly do in the time period allowed. Please let me talk first about several points for you to particularly bear in mind. First of all, the investment adviser has a right to sell, just as in any other business. There was a line of cases in the mid-to-late '60s and possibly even in 1970 and early '71 placing that right in question, but the investment adviser is now protected against involuntary servitude by Section 15(f) of the Investment Company Act, which was enacted as part of the Securities Reform Act of 1975. Bear in mind that 15(f) is a safe harbor, it's not a substantive legal requirement. It was put in to protect against Rosenfeld v. Black, a Second Circuit case, which decision would otherwise have required in all such sales utilizing a fund's proxy machinery, that the purchase price be turned over to the funds, not a desirable result if you've been running an investment company complex for most of your life. But after all, the theory goes, since it was the fund's proxy machinery that was controlled and used by the seller, this, therefore, amounted to a prohibited sale of fiduciary office.
In order for the safe harbor to work, the provision requires, first of all, that for three years the board must consist of 75 percent independent directors, almost double the amount required by the statute; and second of all, that no unreasonable burden be imposed as a result of the transaction. There is a definition of "unreasonable burden" in the section, but you can understand it if I tell you that what it is intended to do is to protect against the possibility that the new adviser would use the new fund's assets to recover the purchase price. Now, what acquisitions are we talking about? We have banks, sometimes already controlling their own mutual fund complex, acquiring yet another one. We have mergers among equals of broker dealer organizations, each of which already have mutual fund complexes of their own. In each instance, we have a flight to asset growth and profitability. The transactions can be large and larger, and the prices steadily go out of sight. I remember years ago, and every year when I remember how long ago it's been that I left the Commission, I realize that $10,000 per million of fund shares under management is really not a heck of a lot of money. Prices of 4 percent, now, of assets under management are not uncommon.
Whatever the transaction, there was almost always, at closing, the automatic termination of the advisory contract as a matter of law. Other contracts frequently have such provisions, even though not required. For example, if there are affiliated transfer agents or affiliated custodians, those voluntarily frequently insert the automatic termination provision, and agreements pursuant to a fund's 12(b)(1) plan are required to terminate automatically. In the role of independent directors representing the interests of shareholders and I'm addressing most of this to the independent directors in the room we'll be responsible for determining, in effect, whether the transaction goes forward. In that regard, you will have to exercise due diligence. In going through that process, you should avoid minefields and be advised every step of the way by independent counsel. I don't necessarily say that to get business for myself. I say that because there are few independent directors who know how to handle these kind of transactions, and you should be advised by somebody who knows what is involved and can advise you, and who is completely independent of any affiliation with management. He or she should be providing you with memos covering every step you take, including the details of your due diligence: What do I have to get? When do I have to get it by? And what should I do with it once I get it?
Remember that the funds, on whose boards you sit, were sold to shareholders with certain representations, investment policies, and limitations. They have a performance record, costs, including advisory fees, and everything that makes up the ethos of a fund organization. Representing the interests of those shareholders, you must decide whether or not to support the proposed deal. For example, who is this new investment adviser? Who are its affiliated and control entities? What is its financial and compliance background? Is it capable of providing continuing quality investment advisory and other services? What has been the performance of its fund and non- fund clients? Are there any of the statutory bars mentioned in Section 9 of the Investment Company Act, or does the acquirer's structure make that a potential problem? Anybody who has questions about that, please see me afterward. Does the new adviser have other funds? Are they similar to yours? How will any conflicts be resolved? What has been the sales and performance records of their funds, and how are they marketed? Are there affiliated transfer agents and custodians? If not, who are their transfer agents, custodians, attorneys, accountants, and any other support persons? Will the new adviser acquire the old adviser? Will the compensations of personnel match or will you have a flight to quality or compensation later?
These are just some examples of what your due diligence includes, but that's only part of the exercise. The independent directors must be prepared to approve or not approve the new advisory contract and determine whether to recommend the transaction to shareholders. In that connection, there will be a proxy statement, and there is case law requiring that the basis for your decision to proceed must be stated in detail in the proxy. Depending upon the timing, you may also have to determine whether to continue the contract with the original adviser, since the acquisition deal may not close or may be delayed past the time when the original contract terminates by lapse of time. For those of you not familiar with them, I've described what we call 15(c) - procedures that are necessary for you to follow. You will find them on Pages 2 through 15 of my materials. Ordinarily, these transactions will also involve regulatory considerations. For example, if there is a bank in the picture, various of the many banking statutes, rules, regulations and letters may impact upon the permissible aggregate holdings, for example, in the complex, post- transaction. That may or may not be a deal stopper, but you certainly should know about it. Was the affiliated broker of the acquirer a repo party for your funds, or were there other principal transactions that your funds did with that broker? You will probably need relief from 17(a) of the Investment Company Act if that's the case.
I have mentioned these regulatory concerns just on the Investment Company Act side, and one on the banking side, but you'll find them in my materials, beginning on Page 16. A word about reorganizations very quickly, since time is fleeting. Acquisition transactions likely will involve, usually sometime well after the closing, possible reorganizations. Usually, these will be mergers of some of your funds into some of their funds, or both funds into a merged fund. Open-ended or close-ended are also possible, as are numerous other potential reorganization transactions. The directors of the acquirer have some concerns. These include such things as whether unaccounted for liabilities are being assumed, tax issues, dilution, new directors, and personnel of their investment adviser. But it is the independent directors of what I call the decedent funds who bear the biggest burdens. I've set out some of the most important considerations for them at Pages 19 to 24 of my materials, and we may get into some of them as we go along. Thank you.
Mr. Roye: Dave, before we on to the independent directors, you mentioned the importance of the due diligence process. How would a board approach that, and how would you, in counseling the board, really approach that process? Would you be initiating questions to the acquiring firm, or other approaches? Could you maybe briefly touch on that?
Mr. Butowsky: I would first prepare a list, if I'm representing the independent directors, obviously, of the materials that should be supplied. I would then have a meeting with the directors and tell them what we have asked for and why, and explain to them what their responsibilities are. Once we've received the materials, we would examine them to determine whether there's anything else that we need or there were any important legal issues that have to be resolved. We would then have a meeting with the independent directors, tell them what our findings have been, and be prepared – tell them the questions that they ought to be asking, and respond to those questions.
Mr. Roye: Have you seen situations where there is a need to go beyond counsel and bring in outside experts, accounting firms –
Mr. Butowsky: First of all, we always, my clients always use outside experts. They use their private accounting – their independent accountants, for example, to measure profitability. They use a service which specializes in putting together statistical information that is required by such cases as Gartenberg and its progeny for presentation, and also, this provides us with people in the event that there is a lawsuit to explain, sometimes better than the independent directors can, exactly what they did and why they did it.
Mr. Roye: Dawn-Marie?
Ms. Driscoll: Thank you. And thank you, Dave. That was a very good summary. It brought back lots of memories. I'm going to start with a little philosophical preamble to my remarks about the process and what directors actually do. In my view, the most important thing that this industry offers shareholders may surprise you. It's not performance. It's not low fees. It's not professional management. It's not outstanding 21st century service. In my view, the most important thing that this industry offers shareholders is its integrity. This is a thing we've heard before. But we are talking about $5 trillion of uninsured money. Directors think all the time about the fact that their shareholders send money off in the mailbox to a fund that can't exactly kick their growth and income fund, and they have a great deal of trust. Therefore, in my view, that's the most important responsibility of directors, and particularly independent directors, is to oversee the trust of this industry. I don't happen to think we should second guess shareholder decisions, particularly their investment decisions. We make it clear what it is they're buying, what the risk parameters are, what the total costs are. They can make that decision. What they have a harder time, I think, understanding, is the integrity of what they're buying.
You heard a lot on the other panels about the day- to-day activities of independent directors, and I think you now have a picture that over the years we have a good sense, from our adviser, what their values are, what their policies are, whether it's brokerage, evaluations, or shareholder servicing. When an acquisition comes along, this is D-day for independent directors. You may be talking about a whole new ball game, a whole new team. And I think this is probably one of their most solemn and serious responsibilities, is to do their due diligence with regard to an acquisition. So what I want to do is not repeat some of what Dave has said about the legal responsibilities, which I think are pretty clear, but to kind of give you a word picture of what it is we do when we are presented with an acquisition. So picture, if you will, a boardroom with directors of the caliber of a John Hill, a Bruce MacLaury, a Manuel Johnson, a Don Dick, a Norman Smith. And parenthetically, I think I should say, you know, we've seen complaints about directors sitting on multiple funds. I ask you as a shareholder, which would you rather have doing the due diligence about an important issue with regard to your fund, a group like the individuals I just described, sitting in a boardroom with their adviser, or 500 directors, all of whom each sit on one fund in an auditorium like this. The process is not going to work, in an auditorium kind of boardroom. I've emphasized the word "Work." I think when you have an issue of an acquisition, directors have a lot of work to do.
My handout was 22 questions that independent directors might ask, and you will be glad to know I'm not going to go through all 22 and answer them. I do want to highlight a couple, to sort of give you an idea of what we do. One of them is: What is the timing of the acquisition? Directors cannot be rushed in doing their homework on an acquisition. I should have gone back and counted them up, but my recollection is that when the Scudder trustees were looking at the Zurich transaction, we probably had 25 meetings that year. Now, not all of them were solely about the acquisition, but I can guarantee you that we discussed the acquisition at every meeting, and that doesn't include telephone conferences among the directors in between meetings. Number 7 parallels the question, should you hire outside consultants? I'm not a big believer in over-lawyering things, but I think if there is a time in which the adviser needs its own lawyers, the fund needs its own lawyers, and the independent counsel needs their own lawyers, this is one. I want to underscore the importance of outside auditors, not only looking at issues of profitability, but cost allocations and understanding the financial aspects of the transaction. I would include outside industry consultants. I think it was Don Dick who commented on the last panel about how important it is that directors take the time to understand what is happening in this fast-moving industry.
Again, this is the time that you might want some of these consultants involved with you in the process of analyzing this transaction. Number 14: What is the acquiring company's reputation for integrity, and what is the reputation of its senior executives? This is due diligence that sometimes doesn't come up on an SEC or a '40 Act checklist, but I think it's very important, and it's not something that you can find by reading a paragraph in the annual report or by looking at a line on a resume. This is something that also requires a lot of homework on the part of independent directors, so that they are satisfied that the values of the acquiring company will match the values that they have established over the years with their adviser. And I'm not just talking about legal compliance. I'm talking about things like frank and open communication, giving enough information, the respect that they treat independent directors, and not just a couple of independent directors, but all of them. Number 15: Obviously, who is going to oversee compliance and ethics? What are their standards? I've said that shareholders can read the materials that we put out, plain English or otherwise. They can talk to their brokers, they can talk to the telephone representatives, they can read the financial magazines, they can look at the cost tables. It's hard for shareholders, I think until it's too late, to get their arms around issues of integrity. Directors, like all of you, read in the paper about long-term Capital or Orange County or everything else, and they say, "Those are smart people." Do we have smart people at our fund, with our adviser? Do we have them on the compliance side? Do we have them on the information technology side? How can we track what our people are doing? And who is going to be in charge of the compliance and ethics standards of the acquiring company?
Number 16: Have there been similar mergers or acquisitions that have not worked, and why? Again, this goes back to understanding what is happening in the industry. I think you can learn from other transactions that have gone on before yours and find out what questions should they have asked that we haven't. Number 17: If we need new directors who should they be? Dave mentioned the 75 percent requirement. There's been the suggestion made that the acquiring company, particularly if it already manages funds, may want to suggest candidates to fill out the Board. It's just my personal opinion, I don't think that's a good idea. I'm a great believer in independent directors choosing other independent directors who the adviser does not know. I know that puts chills of fear in some advisers but I think that independence is one of the most important characteristics of an independent director. The more ways that you can ensure independence the better the process will be.
Question No. 20. What happens if we don't approve this? I think you have to answer that question and that involves understanding why this acquisition has been presented. Is the adviser simply cashing out or are they looking at access to capital as this industry and all its technological Y2K and salaries and everything else gets more expensive? It may be that if you don't approve this you have to figure out what your next move is going to be. And Number 22, the final question, what other questions should we be asking that we haven't? I think we should ask that of our lawyers, of our accountants, of our outside consultants, of other directors, other companies that have gone through this. I think this is a question that certainly I've heard independent directors ask at their director professional conferences with regard to their own Boards. How can we do this better? What things should we be doing that we're not? And certainly there's no more important time I think than in an acquisition to be asking that question. Joe?
Dr. Hankin: All, thanks for the opportunity. I come to this panel as someone who's been a community college president for 32 years and who has been on one fund Board or another for a dozen. I began in 1987 as an independent director of FundSource sponsored by Furman Selz under the tutelage of Ed Agem and John Pollege. We quickly got involved in enterprises known as Continental Asset Management Funds and Olympus Funds where I came to know Jeff Steele, your former colleague with Dechert, Price and Rhoades. As Barry Barbash has pointed out, back in 1995 a Goldman Sachs study predicted an urge to merge. That within five years the investment management business would be characterized by 20 to 25 giant firms, each with at least $150 billion in assets under management. At one point the SEC's Division of Investment Management received merger-related applications at the rate of about one a week. He went on to tell us that The Wall Street Journal proclaimed in one headline, "It's a broker. It's a banker. It's a mutual fund group." Bigger, of course, is not always better. He also told us that one consequence of consolidation is that it may reduce the number of distribution channels available potentially making available funds more expensive to the investor who hardly knows how much her or his funds charge. In all this the role of the director, especially the independent director, becomes more important. You can't see it because there's no overhead projector, but there's an overlay here that shows a little minnow being gobbled up by a larger fish and in turn by two larger fish beyond that. In my experience the Olympus US Government Plus Fund became AMED, which in turn became a Fortus Fund.
A new group was then formed called the Pacifica Fund Trust, first with the San Diego Trust Company and then with the First Interstate Bank of California, becoming the sub-adviser, Dreyfus, the current distributor and administrator, and the Pacifica American Fund, the trust. Dreyfus was replaced by the Pacifica Funds as distributor and the whole enterprise was reorganized with a Denver-based West Corp. trust. Two independent trustees of the latter joined three of Pacifica. This entire enterprise was subsequently joined to the Wells Fargo Bank, Stagecoach, and Overland fund groups in 1996 and I was the surviving independent director to go on to the Stagecoach Board. This was done because the old Board insisted that there be at least one carry-over Board member. Now I had withdrawn from consideration and suggested one or two others whom I felt to be better suited but they selected me so here I am. This odyssey is not yet complete, believe it or not, for Wells and Norwest have now joined as most of you know. They're in the process of merging their funds. This enterprise has gone, therefore, from a $200 million fund group when I first became involved to a $27 billion group under Wells being merged with a $25 billion group of Norwest into a larger group of over $50 billion. Not only did the outgoing Pacifica Board insist on representation on the new Stagecoach Board but as independent directors we felt that some of the proposed fund mergers were inappropriate and insisted on re-working the organization of them into more compatible groups. So what were some of the other heightened due diligence functions and activities from the point of view of the independent directors? And if this sounds repetitive let me put on my educator's hat and say it's reinforcing rather than repetitive. (Laughter)
But I went through my notes and minutes of all of these actions and distilled out a number of things that I considered to be the most important things. To determine the benefits and risks as well as the cost of each transaction, to make certain that the transaction wouldn't result in a dilution of the interest of the fund's shareholders. To scrutinize the organization and personnel and the financial condition, the investment experience and performance, the marketing capabilities, the administrative and compliance review system, the fairness of the terms of the transaction. The acquiring fund's track record, the sales cost and expense ratios of the acquiring fund, and the availability in the acquiring fund of comparable shareholder services. Also to retain independent counsel, which is absolutely a prudent step, to oversee the advisory contracts with the funds. In the meantime, you might wonder how our role changed with regard to regular ongoing business during all of these activities. Frankly, we continued to do our jobs at protecting the shareholders to the best of our abilities. Among our responsibilities we continued to perform due diligence, approve minutes, check performance, assess market conditions including the Fed easing rates three times, engaged in compliance reviews, review 1787 transactions, and look at 10F3 transactions, approve dividends, oversee capital gains distributions, review the Codes of Ethics, appoint sub- advisers, accountants and, indeed, all service providers and replace them as necessary or where we felt that one or another would provide better service, and so on. In short, our role was to keep the ship steady during the voyage through so many shoals. A columnist recent wrote that, "The mutual fund industry is like cable TV, lots of choices but most of them are reruns." It was our objective as both interested and non-interested directors to make sure that the shareholders were properly represented throughout. Despite cases like Navellier and Yachtsman we did so.
We need the strong support of the Commission in reinforcing our roles as guardians. There's always a lot of talk in articles and the like about how independent can independent directors be? Witness the recent Wall Street Journal articles in the last month. I have found that in my experience my fellow directors have, indeed, furnished the independent check on the management of the company, have acted as fiduciaries, have been fully informed, have exercised their independent business judgment including the duties of loyalty and care. Where there were different compliance practices the directors had to choose which ones were best. We knew that we would be judged in accordance with the business judgment rule that court cases focus on a number of factors including advanced dissemination and review of written materials by the directors, consultation with management regarding material issues, consultation with financial and legal advisers retained by the Board, review of the documentation in question by counsel with the Board. Due deliberation at Board meetings, and not rushing. The willingness to act independently and raise questions concerning advice received and a demonstrated concern for the effects of the transaction on shareholders. If I've said that three times that's because it is our most important function.
In summary, fund Board and directors have a number of obligations, to satisfy themselves that transactions serve the interest of the fund, of course, but to examine the credentials and track record of the proposed investment adviser carefully. Does the acquirer currently manage mutual funds? How is their performance compared to others? What benefits are expected to accrue to fund shareholders as a result of the proposed acquisition? Will shareholders be disadvantaged? What additional service or fee reductions might be negotiated as a result of economy of scale? At the least directors should seek commitments that the fund's pre-merger fee structure and expense ratios will not increase. Although the funds themselves are not parties to the merger agreement, directors should understand the legal structure of the acquisition transaction as they might relate to employment agreements, retention incentives, fund, board and shareholder approval, and indemnification, to name a few. Will the acquired adviser's personnel be asked to relocate? Will that result in a loss of personnel and experience and performance? Will current portfolio managers be replaced? Will funds be managed differently? Will philosophies change? What are the styles and cultures of the two organizations like? Will oil and water mix? What are the financial conditions of the acquirer? If it is a subsidiary of a larger company, as has happened in a number of these instances, will sufficient capital be available to support the advisory business? Will any of the product line be eliminated? Will there be substantial changes in fund officers, directors, and counsel? What are the costs of the acquisition and who will bear them? What is the acquirer's compliance record? Will there be additional distribution channels and how has the distribution arm of the acquirer's organization performed in marketing and selling its products? In all of this the independent directors have an opportunity to show just how independent they are and how much they value the shareholders whose interest they protect. In my field I often hear other Presidents say that, "Good Board members ask great questions and accept bad answers." In mutual fund policy directorship there's no room for bad answers.
Mr. Roye: Let me ask a question of the independent directors. In this age where we have, you know, the mega- mergers where, huge financial service firms with far-flung operations where the mutual fund piece of the operation is a significant component but in the scheme of things not significant. You have, you know, the CEOs of these firms, you know, looking at a variety of different factors and thinking when they get the Boards together the deal is done. Then somebody says, "We have to go to the mutual funds and get them to approve new advisory contracts." Are independent directors in the mutual fund framework involved in these mega-mergers really a factor?
Ms. Driscoll: Well, I'll answer that first. I think we're a big factor because we have, essentially, veto power. You know, if they don't care about the funds being part of the acquisition then maybe they don't care very much whether we veto it or not. But, you know, my experience has been, and I suspect it's true with most acquisitions, is that they want the funds to come along. So they have to pay attention to directors. Now they might not like it that this little band of independents are asking them all kinds of questions but they have to satisfy us. You know, I agree with what Joe said, The best thing you can do is to just keep asking questions, taking your time. I mean this is the real moment in which you have a big stick and they do have to pay attention.
Dr. Hankin: They may see us as a fifth wheel but contracts have to be re negotiated and they concur with –
Mr. Roye: The other question I had related to – and I guess Joe, in your case, you've been through so many changes I guess you can't count them on two hands. But how do you keep the shareholders apprised of what's going on and informed in this process? I mean you'd think it's difficult enough for you as a Board member to stay on top of what's going on. How do you bring the shareholders into the process? I think one of the comments that came out of some of the earlier panels is that, you know, is there some disconnect between the funds and the shareholders? How do you relate to shareholders and get information to them, you know, when there are changes like this impending for their funds?
Dr. Hankin: There is the potential of disconnect. The shareholders are interested in two things I think: stability and performance. If that is met and if there's regular communication which we have an obligation to do in a plain English format, by the way, that there, too. I believe that the shareholders seem – at least through all the actions that I've seen, have been reasonably happy.
Ms. Driscoll: Can I answer that, too? One thing that in my experience directors spend a lot of time on is talking and questioning about what are we telling our shareholders and how and when? You know, we have called the 1 (800) number anonymously acting as a shareholder and asked them questions just to find out what the telephone reps were saying back. You know, we've reviewed letters that have gone out and when the final proxy comes out we have worked on the draft proxy, we've changed language in there; we've added language to make it clear, you know, why this is good, the things that we've considered and what we looked at. So I think there's a high degree of director involvement and I'd say that that's a continuing theme of questions at every meeting and through every meeting, "What have we heard from shareholders? What have we been saying to shareholders?" Then we go out and verify what shareholders are being told as answers to some of their questions.
Mr. Butowsky: Well, I have one client whose here in the room today who goes out and has actual shareholder meetings at the locations throughout the United States which is the basis out there in places like Arizona, Kentucky, etceteras. He gets more than 100 people at each one of those meetings asking questions. I have other clients who on a regular basis report to the directors on what are the complaints that are coming in and how are they being handled? How long does it take to answer the telephone, etceteras? Pretty much akin to what Dawn-Marie was saying.
Ms. Driscoll: We've actually gone out to a shareholder servicing center and sat with earphones on the phones for an hour or so listening to what the calls are coming in and what the telephone reps are telling people. So we're as involved as we can be but we're always looking for new ways to first-hand capture shareholder concerns.
Dr. Hankin: I would think both of those practices are probably unusual.
Mr. Roye: Let's turn to Rachel. Rachel, you can give us sort of a perspective from an acquiring firm as well as some insights as to the globalization of this acquisition process.
Ms. Robbins: Thank you, Paul. I'm here because JP Morgan is a broker, a banker, and a mutual fund. We have over $40 billion in assets under management in the JP Morgan Funds. About half of them in the US and half of them situated in Luxembourg, the Bahamas, Spain, France, Canada, and we've recently announced a joint venture with DKB in Japan. You've heard a lot from the fellow panelists about questions from directors in acquisitions. I thought I might touch on the role of directors in an acquisition that didn't involve a change of control so there was actually no legal requirement for the directors to approve the acquisition. Then, as Paul said, I wanted to touch on some of the challenges in the global fund business. A year ago Morgan acquired a 45 percent economic interest in American Century. This was structured not to involve a change of control, primarily as a business matter so as not to interfere with the entrepreneurial spirit of American Century and not to disrupt their business momentum. Although we purchased a 45 percent economic interest our voting control was significantly below 25 percent. Therefore, we were able to conclude, both as a business matter as well as a legal matter, that there was not the change of control here. Nevertheless, we were very sensitive to the concerns of the independent directors of American Century.
American Century has two mutual fund Boards, both with a majority of independent directors. Our goal really was to keep them informed to make sure they understood the transaction and to make sure they were comfortable that the transaction would not interfere with the day-to-day operations of those funds and to make sure they had whatever information that they needed to satisfy themselves in this regard. In particular, since we are so heavily regulated as a bank holding company and in all spheres of the brokerage business, the securities business, not only here but globally there were a lot of issues. They received a detailed memorandum on analyzing each of the restrictions on our business and how they would apply or not apply to the business of American Century. They wanted to understand what procedural changes would be necessary to their business and they did need to adopt new procedures in the brokerage area and to satisfy 10F3 syndicate purchases in deals in which we were involved. They needed to, for Federal Reserve Banking law purposes, appoint new officers and appoint an independent distributor. We wanted to make sure that they fully understood the implications of those changes. The challenges raised by a global organization I think were really illustrated in this transaction. As I said, this ought to have been a relatively simple transaction because it didn't involve a change in control. Yet, the issues that we all had to understand, including the independent directors of the funds, were staggering in their complexity.
The issues that were raised, and I will not list all of them, but here's a partial list. We looked at issues under the Investment Company Act, obviously, the Investment Advisers Act, the Bank Holding Company Act, the Savings and Loan Holding Company Act, the Securities Exchange Act and Regulation M, the Public Utility Holding Company Act, state gaming laws, the Commodities Exchange Act, the New York Stock Exchange rules, State Anti-Takeover laws, state insurance laws, foreign securities laws, and the list goes on. Needless to say, the American Century Board needed to rely a lot on outside experts, and they were fortunate to have Mike Eisenberg advising them, one of the boards, but it was – it is a very complex process. The memorandum that we received from outside counsel analyzing all these was 26 pages, single spaced, summary. Now, as I said, this ought to have been a more simple transaction, because many of the tough legal issues, the aggregation issues that arise in most change of control acquisitions really were finessed by the fact that we did not have a change of control here.
The fact that the portfolio managers are totally independent of JP Morgan at American Century and are not compensated by or influenced by JP Morgan, the fact that we have strict information barriers, were able to address a lot of the legal issues. And we did not need to integrate our compliance departments, which obviously would have been another major issue, both from a systems point and from a number of other perspectives. Nevertheless, we do meet regularly with the compliance department of American Century to discuss common issues and share best practices. Having said all that, I think we would say that in our experience the US regulatory model does represent best practices which we are exporting in our global business. For example, we are working with clients in offshore funds, working toward a plain English approach in those offshore funds, transparent fee disclosures, codes of ethics, use of independent directors even in jurisdictions that don't require independent directors. These are all standards that we apply globally in our business. We believe that independent directors help provide the safeguards that allow us to engage in sound affiliate transactions in those jurisdictions where that is permissible. On the other hand, the fact that affiliate transactions are more freely permissible in other jurisdictions we find does allow more innovative products and greater availability of alternatives for investors with that protection of the independent directors.
Finally, for acquisitions involving financial services firms, the issues are, as you can imagine, very tricky. Dave touched on a number of them earlier. If the affiliated broker dealer is a major trading partner of the fund, is 17(a) prohibition on principal transactions going to be an unfair burden? Are the tentative three restrictions going to impede a fund? If the fund and a broker dealer both purchase loans and purchase from the same syndicate, do you have a joint transaction? What if the broker dealer receives a fee in a private placement in which the fund is participating? Is that a joint transaction? These are very difficult questions that come up all the time, and it might be worthwhile to take a fresh look, and tweak the regulatory structure, in light of the increasing global complexity and consolidation, because with further consolidation, and it is certainly inevitable that that is happening, there is clearly a risk that fund shareholders could be denied investment opportunities by the current constraints. Information barriers really can pose a solution that both provide the protections along with the diligent oversight of independent directors, but that could also benefit the shareholders. But, having said this, clearly, the job of independent directors is not getting any easier.
Mr. Butowsky: Rachel, did I hear you say that there are numerous international businesses that Morgan has, and now that you have 20th Century, may I ask, are compliance issues presented when 20th Century wants to do business with those organizations?
Ms. Robbins: Compliance issues are presented all the time, Dave. As I said, because we don't have a change of control, many of the tougher issues we've been able to avoid, but yes, that's why we communicate very frequently with them, and regularly.
Mr. Roye: Thanks, Rachel. I would just throw out a question to the entire panel. In a number of these acquisitions, you have an acquiring firm who, you know, doesn't oftentimes come from a background where they're used to having mutual funds in their array of products, or you have a foreign company that is used to a different regulatory regime, different standards. How do directors, in reviewing the transaction, assure that the compliance functions stay in place, that the compliance perspective and approaches that you want to see, and that have been traditionally applied in your organization remain, in light of the acquiring firms and the controlling persons having a different background, a different perspective?
Ms. Driscoll: Well, I'll take that one first, because for us it was easier, I suspect, than in other cases. In the Zurich-Scudder transaction, Scudder was going to remain the investment manager. Now, because Zurich had already merged with Kemper, we made it clear that, and I think it was the intention all along, that it would be Scudder's compliance and ethics program that would be the company wide program. And we were both comfortable and reassured, continually, that that would be the case, and we explored that issue in a lot of depth as to what had been the history at, you know, at other places, and what was the culture and intentions of the new company. But I think you have touched upon an issue. When you have companies, acquirers, that either don't have a history of American mutual funds, I think there's a bit of perhaps education coming from the directors to the acquirer, as to the standards that we have in this industry, including dealing with directors, that they're going to have to comply with. Joe?
Dr. Hankin: I really don't have anything else to add to that. I mean, the Q&A is often known as a question and avoidance session, too.
Mr. Butowsky: I've had a number of clients that have been acquired by international organizations. One of the things that they frequently do is have the senior executive officer of the acquiring company – I'm thinking of one situation in London – come over and assure the directors as to the extent of their commitment to compliance and to American rules and regulations. And then we've had people go over to that organization, examine their compliance systems and procedures, and see whether they present any problems. For example, in Japan, it's very tough to get anybody to tell you whether a transaction is a principal transaction or an agency transaction, although if it's a transaction that has an impact in the United States, you know that 17(e)(1) is applicable, and somebody is going to be on your case if you haven't done that compliance step.
Mr. Roye: When these major transactions are often announced, they are, you know, lauded, and people talk about synergies in the press releases, and the benefits of the transactions. Are we seeing the benefits slide down to the mutual fund investor in these kinds of transactions? And this ties into a question from the audience. The question is, do directors have an obligation or should they, in some of these transactions, try to negotiate some of the purchase price for the benefit of the shareholders? It's not – you don't see that.
Ms. Driscoll: Well, I can try and answer that one. You know, in our case, it wasn't that the adviser was cashing out. You know, it was more of a merger. And so, you know, there's no sort of pot of cash that you can distribute to the funds. But I think, to answer your first question, about the benefit to the shareholders, that's what we spent, you know, 25 meetings talking about: what are we getting here for the shareholders, and how can we measure it six months from now, a year from now, two years from now, three years from now, whether what we had expected really happened. I can just tell you, in our case, if a shareholder would have called me and asked, and said, you know, "A year later, what have you seen," I'd say, you know, even five years ago, I don't think I would have said the $100 billion company was too small. But in this day and age, it may be that you do need larger institutions for things like that I mentioned before: access to capital, 21st century technology, forget the year 2000 issues for a moment, issues of back office operations, you know, checks and balances, the things that you don't read about in the press that aren't kind of sexy to talk about, but what directors talk about all the time. Hopefully, an acquisition that's well thought out will bring you that. In the case of the Scudder-Kemper, you know, on our side, we got some very good fixed income managers from Kemper now working on some of the Scudder funds. And I suspect if you ask the Kemper folks, they would say that they got some very good international and equity folks from the Scudder side working on some of their funds. As I said, I think Scudder has a reputation for good compliance and values throughout the company, and to the extent that that was extended to Kemper and now globally to Zurich, I think that's a plus for all shareholders.
Dr. Hankin: In my experience, the acquiring firms have been so market-oriented that they have been very cognizant themselves of the shareholders. If the independent directors didn't raise the questions themselves, which they have been, I think that they might have been raised anyway.
Mr. Roye: Oftentimes, in connection with these transactions, the next step or even contemporaneously with the acquisition, the subject of merging and combining funds, you'll have duplicate funds coming from the respective groups that are coming together. Could you maybe touch on some of director considerations when you're combining funds, and what you focus on in those kinds of situations?
Dr. Hankin: What is the objective of the funds and is the match a direct one or is it a forced match. As I indicated in my remarks, we in fact felt, in some instances, they were trying to force it into something which was inappropriate, and as independent directors, we refused to agree to it. And that was changed.
Ms. Driscoll: We didn't – we had a little different situation. We didn't merge any funds, because we had two different distribution arms. So I suspect Joe has merged a lot more funds.
Dr. Hankin: We actually have that right now, because there's a whole family of funds from Wells and a whole family of funds from Norwest, and some fit very comfortably and others don't, and so we're going through that whole exercise at this very moment.
Mr. Roye: Dave, have you seen situations where the driving force for some of these mergers, I guess maybe special situations where the driving force for a transaction is actually emanating from the directors themselves?
Mr. Butowsky: Well, sure. We see situations in which one of the funds is just not selling or is not performing, and there's a need for either a merger or a liquidation of the fund. It's no good for shareholders to have a fund that isn't profitable to the manager. That's one reason. It's a stick out reason. And there may be others, as well. Dawn-Marie, Joe?
Ms. Robbins: I think that some of them were mentioned earlier, also, the need for more capital for technology. And all of those are very real. Access to a different client base, those are real drivers that I would think would drive that situation.
Mr. Butowsky: By the way, I think that mostly the interests of the adviser and the interests of the directors and the interests of shareholders in 95 percent of these cases are the same. People want to have successful funds, funds that will sell, funds that should be merged because it makes sense. You just have to make sure that the expense ratios, the comparability, investment limitations, restrictions, all of those things, which are in detail in my memo, are taken care of, so that you can have a merger that makes sense and that won't be attacked.
Mr. Roye: We've looked at, you know, situations where they don't quite fit within some of the exemptive rules, and directors have had to make findings that the transactions are in the best interests of the funds. And we've seen transactions where the combination of the funds results in a taxable transaction, the expenses of the surviving fund are higher than the fund that's disappearing, the expenses of the transactions are being borne by the funds themselves, and the directors have still made a finding that that's in the best interests of the funds. Any reaction, Dave, as to how they get there?
Mr. Butowsky: Well, I didn't get a call on any of those.
Mr. Roye: Okay. I think we've taken up our allotted time. I'd like to thank the panelists. We've had an interesting discussion. And we'll pick up with our next panel.
(Applause.)
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Issues for Independent Directors of Closed-End Funds, Variable Insurance Products Funds, and Bank-Related Funds
Mr. Gonson: Good morning, ladies and gentlemen. My name is Paul Gonson. Until two months ago, I was the long-time solicitor of the Securities & Exchange Commission, and since the beginning of this year, I am a part-time consultant to the SEC, and counsel to the law firm of Kirkpatrick & Lockhart in Washington, DC
This panel is a three-bell ringer. The panelists will discuss the roles of independent directors in three specialized kinds of funds: closed-end funds, bank-related funds, and variable insurance products funds. Here is how we're going to proceed on this panel: we are going to do it a little bit differently than the previous panels, because of the three different subjects. We are going to divide the entire time for the panel in thirds. And, by the way, since we're starting late, we probably will run about 15 minutes or so into the lunch hour. First, two of our panelists will take the lead in discussing closed-end funds. Each of the two will make an approximate six-minute presentation. And then all of the panelists who wish to do so will chime in on the discussion and answer any questions. Then, second, we will continue this format with the panelists making presentations on bank-related funds, followed by a discussion. And finally, one panelist on variable insurance funds, followed by a discussion on that subject.
I would like to introduce all the panelists in alphabetical order, starting on my left, your right: Diane Ambler is a partner in the Washington, DC office of Mayer, Brown & Plat, and a contributor to the American Bar Association's Fund Directors' Guidebook. To her left, Kathleen Dennis is senior managing director of Key Asset Management, Inc., and is responsible for Key Corp.'s proprietary mutual fund business, the Victory Funds. And she is located in Cleveland, Ohio. To her left, Deborah Gatzek, is general counsel of the Franklin Templeton Group of mutual funds, and is responsible for operation of the legal and compliance departments, and she is located in San Mateo, California. I had promised her early spring weather, with the cherry blossoms just starting to bud.
(Laughter.)
Mr. Gonson: To her left is Richard Herring, who is the Jacob Safra professor of international banking at the Wharton School, University of Pennsylvania, in Philadelphia, and director of Wharton's undergraduate division. He also is a trustee of a number of BT mutual funds. To his left, Wilson Nolen is an independent director for a number of Scudder's mutual funds, including closed-end funds. He has been an independent director of at least one Scudder fund since 1970, and served on the inaugural boards of one of the first small cap funds and one of the first country funds. Mr. Nolen taught marketing at Harvard Business School. He is located in New York City. And to his left, Bradley Skolnik has been the Indiana securities commissioner for four years, and is the president elect of the North American Securities Administrators' Association, which we all know as NASAA, the umbrella organization of the state securities regulators. Previously, he practiced law in Indianapolis. Mr. Skolnik is located in Indianapolis. We will now start our panel with a discussion of closed-end funds. Mr. Nolen, who is a fund director, will speak first, followed by Ms. Gatzek. Mr. Nolen.
Mr. Nolen: Thank you very much. I think that what I am about to say will be made more interesting if I informed you that that article in last Friday's Wall Street Journal describing certain, quote, "independent directors" of certain closed-end funds described some as having a compensation that was the equivalent of as much as $400,000. I thought that was very interesting. That makes me – by process of elimination, I'm that person. That makes me not only the oldest person here, but presumably, the most highly compensated. Unfortunately, if the journalist had simply said that I was on this fund because I was young and handsome, I wouldn't have minded that, and would not have cared that there was no source for it and it wasn't true. But as to the $400,000 of compensation, you know, I just had to ask, "Show me the money."
(Laughter.)
Mr. Nolen: Compensation – And I want $300,000 right away, from Scudder.
(Laughter.)
Mr. Nolen: The open-end funds, I could say a lot of things about the difference between open-end funds and closed-end funds, but the thing that is interesting to everyone at the present time is the issue of discounts from net asset value in closed-end funds. I'm going to talk about this issue. I would like to start off, I'm going to talk about it from a historic point of view. I'm going to offer a law, and I'm going to call it Oliver's law, which describes discounts and the consequences of them. Why Oliver's law? I have a grandson named Oliver, who has pointed out to me that a lot of laws have first names, so I thought it was nice to have one for him. The better a closed-end fund performs, the higher the absolute amount of the discount in dollars and cents, and the greater the pressure to open-end it. On the other side, the poorer the performance of the closed-end fund, the less the dollar amount of the discount and the less the pressure to open-end it. So success brings pressure to open-end. Secondly, the only way that new money can flow into a closed-end fund is through rights offering. Irony once more. The greater the froth on the closed markets served by the – the markets served by the closed-end fund, the greater the opportunity to have a right offering. The worse the situation is in that market, the less opportunity there is to offer a rights offering. So rights offerings tend to be made when the market is high, the opportunity is little, instead of when the market is low and the opportunity is great. These are ironies that have affected this fund.
Now, I'm going to go around and look at the history of these funds and why the discount exists, and what do we do about it. First, the closed-end fund has a very long history. The important ones, they were one of the most important part of investor – small investor participation in the market in the 1920s. Every great investment banking house sponsored one. The ones that weren't leveraged survived. Several of them are still extant, and they still have discounts after three-quarters of a century. At the same time, these fund, I could mention two, or several are mentioned in the footnotes in one of the papers you'll see here. Tri-Continental and General American Investors, after 75 years, still run with a discount. Now at the same time this was going on, two other kinds of mutual funds were developing. Scudder, a man named Scudder, invented something called the no-load fund, now called pure no-load. And you could get the same portfolio that you would buy through General American Investors with no commission charges and the rates were very low, and there was no marketing support for this. It grew very slowly. In the middle, there was another kind of fund which was an open-end fund with large front-end commissions, 4 to 7 percent. As it turned out, the market shares of these three funds developed in quite different ways. On the one hand, sophisticated investors took the Scudder-type fund, pure no-load. Some people took the closed-end fund. But since you could get the same portfolio in the middle fund, that is, the open-end fund, a lot of people took that. In the beginning, you would say, "Why does this exist?" Well, in those days, the marketing was all important.
Although these funds might have a management fee of 3/8th's of 1 percent, the brokerage, before Mayday, was huge, and the investment banking houses, with this huge amount of brokerage, could do some rather effective marketing. Although the management fee was peanuts, the profits were huge. Alongside of it was running these new open-end funds. Why were these fees as high as 7 percent? Well, if you look at what brokerage fees were at that time, 7 percent was roughly as much as the brokerage fee to go into close-end fund and come back out again. So the customer's man would get as much compensation, and he would get it in advance, by selling the new open-end fund, rather than the closed-end fund that had exactly the same content. So from these three types of funds went along through the market, and now we come down, 50 years later, 60 years later, and the open-end fund with commission or the open-end fund no-load dominate the market. Why, in the midst of all this, does the closed-end fund resurrect itself, because they make up only a small part? Im talking about a specific class of closed-end funds, which are the so-called country funds. There are bond funds, and a number of other things like that, that are proprietary products. They have great marketing support. And I won't go into why they have great marketing support.
We started with closed-end funds, with the country funds. And the first, the Japan fund was the first. It was actually introduced by an underwriting house and subsequently turned over to Scudder. It had this very interesting characteristic, that the Japanese market was not exactly open to all the investors. You couldn't buy that portfolio that was in the Japan fund. When it became possible to buy that portfolio, immediately that fund open-ended, so there was no reason to have it closed-end any more. But in the early '80s, it became apparent, something that we now call emerging markets attracted our attention. I'll divide these into two classes: those markets which were somnolent, or almost non-existent; and those markets which, like the ones in Europe, that were going to be subject to cataclysmic change, owing to the development of the common currency, et cetera. In the case of the high-risk country funds, the reason for it being closed in was that you had a country risk, a currency risk, political risk, and the usual things that go on in markets. It was deemed imprudent to try to have a fund that could be opened up so you would be selling into a firestorm. So that made sense, to close it.
In the case of Europe, you could have had a European fund that concentrated in, you know, 15 stocks, and it would have had extremely high liquidity, it would have gone very well. If you start trying to enlarge that to a market of 600 stocks, the liquidity situation looked more like emerging markets. At any rate, these funds started up, and the fascinating fact was that the Korea fund, the first launch, went to a huge premium. Nothing like it had ever happened before. This started out as a pool of cash with a license to invest in the Korean market, and all of a sudden, it went, for an instant, to a 200 percent premium. Nothing like it had ever happened before, which caused the underwriting community to go wild, and all sorts of country funds came along. The Korea fund, all these years later, still maintains a premium, but almost all the other funds since have sold at a discount. The problem, then, for the independent directors is what to do. In almost every prospectus, in every prospectus I know of, there is language about "The directors will consider this," and it has been going on, considering. However, it has turned out that the interest in open-ending is highest for the most successful funds. The Spain and Portugal fund, which is in the process of liquidation – the last trading day March 1st, liquidation day March 5th this year – was the most successful closed-end fund on the market in the years '97 and '98. A lot of the investors would like to have gone on with that record of success, but no, they voted for liquidation. We have just announced that a kind of open-ending will apply to the New Europe fund. Both of these funds would have been open-ended. From day one, we intended that when the markets matured, they would be open-ended. In our case, the directors had to make that decision. But let's look at what the problems were. There were a lot of different ways of open-ending, and the successful fund, open-ending a successful fund with this dollar discount creates a very interesting problem. There are your original investors. Now, these funds were ways of introducing, allowing smaller investors to go into a very high-risk market, and where they were extremely successful, they created huge embedded capital gains tax liability. When those funds are open-ended, any open-ending that doesn't result in liquidation means that it triggers a taxable event for all investors.
Mr. Gonson: Mr. Nolen, as a fund director, is that a consideration that you would take into account, or do you think that disclosure would be sufficient, and then the investors could make up their own mind?
Mr. Nolen: We have disclosure. The situation is clear-cut. There is disclosure on this. The problem is what do you do when different classes of investors have different interests? The investor who wants to go on doesn't want a taxable event.
Mr. Gonson: When you take that into account, to what extent do you take into account the interests of those investors who were the original purchasers and still are there, and presumably want to continue, as against others who have come in later and would like to see it open-ended or liquidated? They both are, of course, stockholders. Don't they have equal claim on –
Mr. Nolen: Yes, that is absolutely right. They have equal claim, and you are the director for all the stockholders. We had this ironic situation occur in one closed- end fund, which I am not involved in, where an absolute return investment group in Europe took up the position, got themselves elected directors, and found themselves in the embarrassing position of holding a very large holding in the stock. They then became inside directors. The profit on the transaction had to go to the fund, because they represented all the shareholders. But this is an anomaly, and I'm going to talk to you about it in this way: Laws have changed about distribution of capital gains since a lot of these funds became effective. When people make laws – you know, Bismarck made a lot of history, but he made one little comment in political philosophy. He said: "It's best that the public not know how either sausage or laws are made."
(Laughter.)
Mr. Nolen: That is often quoted. But the thing I would have to comment is that sausage-makers get feedback from the market, and people who make laws don't.
(Laughter.)
Mr. Nolen: When they changed the rules on capital gains distribution, annual capital gains distribution, all of a sudden you have two classes of investors: those who pay those capital gains taxes, and those that don't. Most of the long-term investors don't want that. That's like float in the insurance business. They want that to grow and grow and grow.
Mr. Gonson: Mr. Nolen, I wonder now whether it would be a good time to turn to Deborah Gatzek, who might talk about, in addition to what else she was going to say, perhaps about the choices that are made at the outset when a closed-end fund is established? But first, I, too, have a disclaimer to make, as you made one, Mr. Nolen, about your $400,000. The chairman, Chairman Levitt, some time ago, indicated that people were being attracted away from the staff of the SEC with offers as much as $1 million. I would like everybody to know that I am not one of those $1 million men.
(Laughter.)
Mr. Gonson: Deborah.
Ms. Gatzek: All right. Let me begin at the beginning, perhaps, with this wonderful historical background that Mr. Nolen has provided us. You're an independent director, and at the outset, you have been asked to serve on the board of a fund that they tell you is going to be closed-end. Well, I would suggest, though, that the first thing you do is make sure that it makes sense for this fund to be a closed-end fund. We're not talking about 1920 or 1980. We're talking 1999. And generally, you should hear something along the lines of, there are valid portfolio considerations. Mr. Nolen alluded to this. What we find today is mostly going on are situations where a fund cannot really be run in an open-end format. My expertise would be in those emerging markets funds. Particularly I've got experience with Russia and Vietnam.
Well, I can tell you that there's no way that you could ever exploit the opportunities that many people see in those two jurisdictions, or people saw in those two jurisdictions, in an open-end format. You're talking about highly illiquid securities. And once you've made your disclosure to the investor that you're talking about a risky situation, you're talking about a place where there is no liquidity, once your investor agrees that he wants to participate in a place like Russia, a place like Vietnam, the only way to do it is in a closed-end fund format. You can't have money coming in, and you certainly can't have money unexpectedly going out. But you as independent directors want to hear management tell you that. You want to make sure that it makes sense. I think when that's the case, you can have a lot more comfort as you face some of the other issues that will inevitably confront you.
In my outline, I set forth a couple of other circumstances in which a fund might be closed-end, but I'm running out of time, so I'm going to kind of power through to what have you said in the initial prospectus about what you will do if there is a discount? You want to make sure that if you've said something very specific, that you understand what obligations you have undertaken, and you want to make sure that you fulfill them. On the other hand, if your language is somewhat more vague, you want to make sure that your prospectus makes it clear to all potential investors that you don't have a hard-and-fast plan, that you're not obligating yourself to take any particular action to address a discount. Very quickly, what are the reasons that a fund sells at a discount? The potential for the embedded capital gains is one of them. Some people say that closed-end funds trade at a discount because of a general lack of interest in the marketplace. Who even knows that these funds are out there? And if this is the case, and many people believe it is, I suggest that the industry and the SEC consider whether it might not be appropriate for closed-end funds to adopt something along the lines of a distribution plan pursuant to – well, it can't be 12(b)(1), because it doesn't apply, but some sort of a plan where the fund, out of its own assets, may pay brokers to service their shareholders in the fund. What that will do if it works right is to have brokers paying attention to the fund. They have to answer questions about the dividend. They have to answer questions that their shareholder clients may have about the portfolio. When a broker has that incentive to keep up his interest in the fund the next time a client comes in for whom that investment may be suitable he may suggest it.
There's another reason that these funds sell at a discount or a premium, and that's the good old fashioned forces of supply and demand. Studies have shown that when cash flows are very strong into open-end funds of a nature similar to the closed-end funds the premium on those funds or the discount on those funds either disappears or there may be a premium. Conversely, when you have money running out of international funds you can expect to see the discounts on the closed-end country funds increasing. There may be absolutely nothing wrong with that. Question, what's so bad about a discount? I'm not sure that there is anything bad about a discount just in the abstract. Many New York Stock Exchange operating companies sell at a discount to book value to some other historical measure of value. But you don't necessarily have people immediately running and saying, "Let's liquidate it. Let's liquidate it." That's a little bit of what we've had in the closed-end funds. Discounts aren't bad if you are reinvesting your dividends. You are getting a little bit more than your dollars worth when you reinvest. Remember also that the fact that a fund is telling you to discount doesn't mean that any particular investor has lost money. For example, you buy at 10 and about two years later the NAV of your closed-end fund is 20 but because of the discount it's selling 18, you're still ahead of the game.
I think this brings us to the real philosophical questions that the directors are going to face when there's a discount. Presumably your prospectus is going to have said something along the lines that you'll consider what to do if there is a discount. The discount comes up and you say, "What should we do?" Well, the hard question is who are you protecting? Mr. Nolan alluded to that. Is it the arbitrator who came in very recently at a discount and hopes to profit in the very short term by open-ending or liquidating the fund or is the longer- term investor who says, "I really want this exposure to Russia, to an emerging market, to Vietnam. That's what I want. I want the chance to see these small companies grow. I'm not too concerned about the fact that those are discount." Now that's something that is frequently solved by the shareholder vote because, as you know, many times the arbitrator will come in with a shareholder proposal. As any of you who have been following the course of these actions know, it's pretty difficult to not include a shareholder proposal in your proxy statement. So sometimes you're going to have a popular vote and your shareholders are going to say whether they want to continue or not. But I suggest that that's a very difficult philosophical question for the directors.
Mr. Gonson: These are always phrased are they not in terms of recommendations –
Ms. Gatzek: Correct.
Mr. Gonson: – which I guess theoretically the Board could take the lead.
Ms. Gatzek: That's correct. I would suggest that the reality is most Boards will not ignore a suggesting to open-end when it's been voted on by a majority of the shareholders.
Mr. Gonson: What if it's 40 percent?
Ms. Gatzek: I think 40 percent and then you feel people have voted and you probably would be looking at why 40 percent are unhappy. What can you do with that? But I think that you would – you still might not open-end it.
Mr. Gonson: Would you say that 20 voted no and the other 20 didn't care?
Ms. Gatzek: Well, that could be. We know that; (1) that shareholders are generally not the most activist. But I think if they didn't care they're probably relatively content with their investment. Jumping to my conclusion, I think I would say that for the regulators, for the independent directors, for the entire industry, we need to have an understanding and a consensus as to whether closed-end funds really do have a value to investors. It has been suggested that if the discount is demonized, so to speak, and you can't have a successful fund selling at a discount what you may be doing is telling the small retail investor that he cannot really avail himself of the opportunity for investing in some of these places where he couldn't invest on his own, Vietnam, Russia. Many of the emerging markets, you just can't go there unless you go through a fund. But if we say that or if there's a discount and there's an arbitrator the whole thing disappears and we agree that maybe that's not a good idea then perhaps we and the regulators should look at ways of protecting that format.
Mr. Gonson: Deborah, we had talked about three different events and I'd like to ask your judgment as counsel to companies – when you think fund directors should be advised? One is at the time that a fund is organized and the choice is made to go closed-end. Then the fund directors usually come to that a little late in the game, really. The second is, life is now going on. Is there a presumption, do you think, that the fund once being started as a closed-end should continue that way? And, third, I guess is now the arbitrators, as you call them, have come in with proposals to open-end or liquidate the fund. Then what do you advise the Board? In those three stages what do you think the role of the director ought to be and what kind of advice might you give?
Ms. Gatzek: I think at all three stages the issue has to be a fundamental economic analysis of whether the fund makes sense in a closed-end format. So giving – asked to be a director on the fund don't be a director on the fund if you don't think it makes sense or you have that discussion with the management company. Presumably they have come to the conclusion and they have good and valid reasons.
Mr. Gonson: Now then we have so-called life boat provisions in the prospectus that says when – if things go bad or the discount is too bad then the fund will do so and so – Should the fund director be looking at that continuously or should he wait for an event? Pardon?
Mr. Nolan: Every meeting.
Mr. Gonson: Every meeting?
Mr. Nolan: Absolutely. Let me just make a comment. Deborah brought up the thing of some equivalent of 12B1 for these funds. These funds are brokerage products, not the normal mutual fund that's sold through these large organizations. As a consequence you don't – you have to communicate with the owners through an intermediary, who may or may not be indifferent. The 12B1 would help with that issue. That was the difference between some of the early closed-end funds. They were sponsored – sponsored. All those closed-end bond funds are sponsored. They carry the name Nuveen. And Nuveen sponsored them and so on and so forth. These emerging market funds in particular don't have sponsors. When the road show disbanded, sirenata. That's why the suggestion makes sense.
Ms. Gatzek: Yeah. Well, in our funds we do consider ourselves a continuing sponsor but the truth is it's very difficult to communicate with the shareholders other than through the occasion of your annual and semi-annual reports. Frequently accounts are held through large broker omnibus accounts and you don't know the names and addresses and you can't send the kind of mailings that you might like. But I do think that at every step the directors ought to be convinced that the fund still makes sense as a closed-end fund.
Mr. Gonson: Thank you. Thank you very much, Mr. Nolan and Ms. Gatzek. I think now we'd like to shift to the subject of bank-related funds and Professor Herring, who is the independent director in this group will speak first followed by Ms. Dennis and then by Mr. Skolnick. Professor Herring?
Mr. Herring: Thank you, Paul. My assignment was to talk about what's different about being the trustee of a bank-affiliated fund. I guess I should say at the outset that not much is different. It's pretty much the same business. We have pretty much the same kinds of concerns. There are, however, some points of distinction. So in my six minutes I'd like to make six points about things that I think are a bit different. The first four points all have to do with regulation because it is different in several different aspects. The first is there's just a lot more of it. There's more oversight for a bank-affiliated fund. The particular bank that our funds are affiliated with is Bankers Trust, which is a New York State charted bank. So we are subject to oversight by and inspection by at least three agencies, the SEC, the Federal Reserve of New York and the New York State Banking Department. That can mean for lots and lots of compliance costs except that in general the regulators do a pretty good job of coordinating requests for information. We tend to see the New York State Banking Authority about once a year, the Fed about once a year and I guess the SEC generally about once every three years. They have slightly different perspectives so their need for information is not quite the same but it in practice is not the compliance nightmare that it would seem to be in principle. Do we take comfort in the fact that we're being monitored by three different agencies? Well, if you have a belt and suspenders I suppose you feel a little safer with some safety pins and maybe even some crazy glue, but there's a point at which you have to ask whether the additional safety from oversight is worth the additional cost?
Second, we have additional regulatory constraints. The most obvious one is the Glass-Steagall Act, which banks still must worry about although they worry about it a lot less than they once did because administrative decisions and court decisions have actually reduced its constraints on most other bank activities. But Glass-Steagall is alive and well in the fund business. In particular, Glass-Steagall prohibits bank officers from serving as members of the Boards of mutual funds, although I think there is an exemption for the bank holding company, if it's carefully constructed. Our Board, in fact, is composed entirely of independent trustees. Bank officers are present in meetings when we want them to be but when we're in executive session they're not. My impression is that this actually works quite well. I think there's, at worst, a very slight loss in efficiency and there may be an offsetting benefit in that the trustees do feel very, very independent. It's a pretty feisty group. I can't imagine they would behave much differently if they were bank officers actually on the Board but I think the dynamic is actually a very good one. The more troublesome aspect in which Glass-Steagall constrains our activities, however, is that even though our bank can underwrite equity, it can underwrite junk bonds, it cannot underwrite mutual funds. So we need to employ an unaffiliated distributor. Over time we've had a number of them. Five, in fact, in the life of the fund family, which is not all that long. It has been at worst a distraction but it seems to be the kind of thing that takes up Board time and attention which seems to have very, very little value added to our shareholders.
There's another aspect in which it constrains our business, Glass-Steagall does tend to inhibit our ability to seed new funds and so it probably slows innovation to an extent. Even more of a problem in this regard, however, is the Bank Holding Company Act, which prohibits the bank really broadly defined. We've included the 401-K plans of bank employees. It forbids the bank on this hugely consolidated basis from owning more than five percent of the shares of a mutual fund. Of course, in the seeding process that's a real problem. Another difference which the SEC is worried about has been that banks are exempt from registration as investment advisers. That is true of our investment adviser at Bankers Trust. This, of course, does not mean they're exempt from regulation. The bank authorities have long been very concerned about banks acting as fiduciaries in their trust activities. They are subject to a wide range of regulation in that regard. In addition, of course, they have a very strong code of ethics and very tough compliance. If there is an infraction that would involve the inappropriate allocation of investment opportunities across different funds we would hear about it as a Board and have a full accounting. So although that's a difference I'm not sure that it's one that has made much of a difference in the way we operate or behave. It's my understanding that at least at our bank as a matter of policy we give the SEC access to any information it feels it needs in that connection.
Mr. Gonson: Professor, you and I discussed early this morning that a week ago Friday SEC general counsel, Harvey Goldsmith, testified on behalf of the SEC on the banking bill before the House Banking Committee and he noted the fact that many banks that advise mutual funds are not registered investment advisers and expressed a concern that the SEC often is unable to inspect the trading records of other bank clients such as trust accounts for purposes of detecting front-running and improper trade allocations. Your paper indicates that you think that that probably is not a problem because bank regulators do an adequate job of that. What is your role as a director do you think in dealing with the conundrum?
Mr. Herring: Well, it is certainly an issue that we ponder when we have – and some of the investment advisers through, for example, we who are managing several different kinds of money. We certainly do ask them about the way in which they allocate investment opportunities. So it's not an issue we ignore. However, I do think that the banking regulators have competence in looking at these issues because they have for many, many years been looking at bank trust departments, which have similar kinds of concerns. But I also place a lot of importance on the Code of Ethics. It's really not in the bank's interest to make those kinds of compromises with the interest of their clients. They should have a very tough enforcement regime internally in the Compliance Division.
Mr. Gonson: Yeah, are the funds important to the bank overall?
Mr. Herring: Well, that's the next way in which this may be different. The issue I gather is that most of the large mutual fund families have been at it for years and that is their preoccupation. Although there's some very large bank-affiliated mutual funds, they're generally not large compared to the other business of the bank. So I guess that always does raise troubling issues of the level of commitment, particular when there's so much ferment in the banking world. I was visiting one of my students at a bank – not the bank that's affiliated with our fund, incidentally. We were going out to lunch. As we left he turned to his secretary and says, "If my boss should call while I'm away find out who it is." (Laughter) It's almost that bad. As you may know, we are about to be acquired by a very large European Bank, Deutsche Bank has made an offer for Bankers Trust. It's certainly an issue that we in the Mutual Fund Trustees Group will consider very carefully. We want to be, above all, certain that our shareholders are no worse off and hope to find out that they're going to be better off in several respects. We'll inquire about their commitment of human resources, their plans to retain key managers, their Code of Ethics and their compliance and how they tend to deal with all of the issues that arise under running a – compliant company. I did want to go back to one regulatory issue, which is speculative rather than – thank goodness, rather than actual, and that is one of the inherent problems in having a system with two different regulators with very, very different orientations.
Bank regulators tend to be institutional focused and put the protection of depositors above all else. They tend in general to be at best ambivalent toward disclosure, particularly disclosures which might cause depositors to worry. They are almost hostile to marking-to-market in several cases. Securities regulators obviously have a very different perspective. They're functionally-oriented. They are after investor protection first and last. Always they encourage disclosure at all time and certainly are zealous about marking-to-market. Generally, one can live in both those environments and not get into trouble. But I tried to speculate on circumstances where one might have difficulties and two are pretty obvious. Suppose, for example, that a bank-affiliated money market mutual fund ran into difficulties and was about to break the buck. It's highly likely that the adviser would want, for business reasons, to make sure that didn't happen. Another example might be if there had been a pricing error that had persisted over time and it was a pretty substantial amount of money that would need to be transferred into the fund. If these amounts were large enough they could raise questions with both banking law and with regulatory practice. Banks would be reluctant to see substantial amounts of funds transferred out of the bank for this purpose. That could create difficulties. My guess is that, in general, we would – the bank would find ways to obtain the funds outside of the bank itself with non-bank affiliates. But it would be awkward and a little trickier than it would be if it were not overseen by an institutional and specialized regulator.
Mr. Gonson: Yeah. But what leverage, if any, would you as a fund director have on that?
Mr. Herring: I'm not sure that we would. I think that's –
Mr. Gonson: Well, maybe we should hear it from the bank's point of view. Kathy? What would you say? Dennis?
Ms. Dennis: Do you want me to answer that question or –
Mr. Gonson: Sure.
Ms. Dennis: I think that when the bank is involved in a situation where there are marked-to-market or other problems the directors have every right to be concerned but, quite frankly, there is not a lot that they can do other than perhaps sit back and cross their fingers and hope that management sees the light. And once the decision process begins, there are as with most other bank issues, other regulations which need to be looked at in terms of how they can go back and support the fund. You get into affiliated transactions and things like that which can create other difficulties, but I believe that the banks are – at least the larger banks in the business are as committed to doing it the right way as other companies in the industry.
Mr. Herring: Go ahead, Kathy.
Ms. Dennis: Actually, Richard and I are in a fair amount of agreement on the current state of bank-related mutual funds. Those of us in the banking industry who have been in this for awhile take Glass-Steagall pretty much as normal operating procedure. It's shadow, fortunately, is shrinking, but it is in fact still there. I think the hurdles that come up, actually, are more on the management and operating side than perhaps on those of the trustees. We have to find perhaps a little more round-about-ways to get where we want to get because of these regulations. I gave a lot of thought to how our trustees behave because we are a bank-related fund and I'm going to touch on really three points. The first being the inability of bank officers or management to be on the fund's board. We have eight trustees at the moment on our Victory Funds. All of them, except one, are independent. The one trustee is, in fact, a retired bank executive, although his experience was not in the investment area. What I find interesting in our meetings is that although he is considered interested, I think he would really rather much be one of the independent trustees. I think he feels a little left out sometimes in how the business is conducted and would like to stay in those executive sessions even though he can't. I think there are really some positive benefits. We do function a little differently in the way we run our meetings and do our business.
Management at the bank tends to be a suggestive, a recommended. We somewhat guide the direction of the meetings, but our trustees because they are there as totally or almost totally an independent board are really responsible for the actual running of the meetings, running of the committees. I believe it requires that they do a little more homework in advance, but to a comment that Chairman Levitt made earlier, they are engaged and they are passionate. And that, I think, is really a good thing. A number of positives come out of this. I think because we do not have a management group on the board our trustees feel much freer to challenge what we want to do to make us justify the recommendations that we're making to explain any changes that we might want to have. And they don't always approve everything. We've been, I would say successful in general in terms of where we want to go, but we certainly don't take anything for granted when we walk into the board meetings.
I think another positive is as I mentioned before, these directors are all – they're very engaged and they're very involved in the discussions. I think as a group, they make a particular effort to be knowledgeable as to what the issues are. They don't spend a lot of time pondering bank regulations because they are really only indirectly impacting them, but they are really interested in what's going on in the mutual fund industry. I think from a management perspective, and this is really a positive, that we work harder with our trustees to build a working relationship. We spend a lot of time communicating with them both before the board meetings, we do reviews with the chairmen of the committees to go over the agenda to talk about issues that might come up. We give them outside of the board meetings a lot of written communications on business plans, our results. We call them when unusual activities occur. We, for example, bought a broker dealer back in the fall of this year, McDonald Investments, and although there was no immediate impact on our fund trustees, we did call them all, rather than have them read about this in the paper and wonder what we were doing in our ongoing bank reorganization process. We share with them other organizational changes. We bring other management people to our dinners and so on. And I think all of that helps them understand the commitment that we're making to the mutual fund business.
On the distribution issue, I think our trustees understand and don't really think about anymore why we have a outside distributor. It's not really something that concerns them there. In fact, much more concerned about what's going on in the sales process, not because they have a regulatory requirement and not because they're involved in the sales practices of our broker dealer, but because they're concerned from a business perspective that our shareholders don't understand the legal structure and that any client who walks into a bank and buys a fund that is, by appearances, belonging to that bank, that perhaps the ultimate burden, if there is a sales practice problem, that there could be some reflection back on the trustees of the funds. We spend a fair amount of time, not necessarily every meeting, but periodically we've brought in management from the broker dealer to talk about sales practices and compliance. We talk a little bit about how we go about marketing of the fund in the distribution channels. We also talk from time to time on how the brokers are compensated both for selling our funds as compared to other non- proprietary funds . Again, all of that is to give the trustees a level of comfort that we know what we're doing and that there is the proper structure in place within the company to keep both our shareholders and, ultimately, others out of trouble.
Lastly, I wanted to talk about some interesting transactions that our trustees have had to address. Because we are a bank, these are things that may don't come up in other non-bank companies. We have the ability to offer a number of services to the funds. A couple of examples, we obviously can be custodian. That's no so unusual these days. We can act as securities lending agent. We can offer lines of credit, services like that. And what we found with our trustees is the first question that comes up is, "Is this an affiliated transaction? There could be a problem." They rely on fund counsel and counsel to our independent trustees to get that answer. Once they get by that, then the real fun begins and, typically, the first question that comes up is, "Well, you know, Do you, the bank, want to do this because you're the bank and you're going to make money? You know, "Or is it really good for funds?" So the challenge is on us at that point to justify the role that we want to play and the activities that we want o do. I think the big example that we had of that was when we undertook securities lending. He was acting or wanting to act as securities lending agent and there was a great deal of concern that we were doing this only because it was good for Key Corp. And we spent a fair amount of time in the meetings discussing the risk, how we were going to monitor that risk or reduce that risk, how the funds were likely to benefit, how the compliance would work. And it actually took several meetings before we got a level of comfort with what we are doing. And I think now we've pretty much moved beyond that. But we were truly asked to justify the reasons that we wanted to be the provider of the service. Another issue that we run into in that area is you, the bank, are the service provider, what additional burden does that place on the fund? And the example of being a custodian, the affiliated custodian has to do three securities accounts. That burden is not something that the trustees care to pass along to the shareholders. So, when we look at all of those related costs, we still need to be competitive with other service providers. I think that's pretty much –
Mr. Gonson: Kathy, one thing you said earlier I guess triggers this question in my mind. And that was I think that the fund directors sort of take the structure of the law as they find it. From the securities regulator's point of view, there's always this sort of problem that the Glass-Steagall relationships don't always work well from, as I said, from the securities regulator's point of view. Is that ever a concern for the directors one way or the other? Or do you ever talk about that? They say, "Well, the system that we have, the way it was structured," you mentioned that you had to deal with, you know, and as well as Professor Herring, different sets of laws to try to make this work.
Ms. Dennis: I don't think they find it a particular problem as long as things are going well. And that, again, probably puts a little bit of burden back on to management to make sure we know what we're getting into and that we're prepared to deal with the somewhat circuitous route you have to go.
Mr. Gonson: Now, we want to hear from the state regulator's point of view about all this. Brad Skolnik.
Mr. Skolnik: Thank you, Paul. For state regulators, fund governance has not typically been an area of really major focus. As the grassroots regulators that really concentrate very heavily on the retail point of sale, fund governance issues are not an area that typically comes, that comes up in a lot of state securities divisions on any regular basis. However, we do have some concerns, and I think Kathleen alluded to some of those. We do have some concerns regarding sales practice activities on bank premises. This is an area that has really – that both the media as well as regulators and industry have focused on in the last several years, partially in response to the NationsBank scandal as well as from time to time both regulators and industry groups have adopted provisions and rules to deal with the concerns that have been expressed. While the sale of securities products on bank premises is very convenient for many investors, it is also the source of confusion for others who may not fully understand that the investments are not FDIC insured deposits. And because of that, we have seen on a retail basis problems that have cropped up really throughout the country from time to time. The fact that this is an important issue is I think reflected even in the number of the guidebooks that are published for fund directors. For example, on the APA Guidebook for Fund Directors, it's noted, and I quote, "Sales practices are a particular concern for fund shares sold on bank premises."
As a regulator, though, I'm led to ask the question: What if anything can we expect directors of bank- related funds to do in monitoring or encouraging the prevention of sales practice or discouraging sales practice violations in connection with the sale of these funds on bank premises. It is not an easily answered question, I don't think. First of all, prevention of sales practices violations do not fall within the traditional role or duties of fund directors. I think we need to keep in mind that a fund board cannot be expected in any practical way to oversee the day- to-day sales activities of a sales force, even if it consists of representatives of, say, a bank-affiliated broker dealer or the bank employees, themselves. On the other hand, fund directors are responsible, I think, for the orderly management and distribution of the fund. And because of the rather unique circumstances presented by the sale of bank-related funds on bank premises, the directors of these funds I don't think should simply turn a blind eye to the potential for confusion in sales violations in the connection with the sale of fund shares on the bank premises. It's important to note here, I think, that I'm not advocating and I don't think my colleagues across the country would necessarily advocate that we somehow expand the scope of liability for fund directors in this area.
What we are really focusing on and what I would encourage and I think it's consistent with what Chairman Levitt has discussed on a number of occasions is that fund directors adopt certain types of best practices that they can employ to ensure that the fund is sold and marketed on the premises of the bank in a manner that does not cause undo confusion and, worse yet, sales practice abuses. A number of these practices are so-called best practices I think can include most of all – most importantly – an effective monitoring system. I think directors of bank-related funds have an obligation to monitor trends and volume and types of customer complaints in any litigation or arbitration that results from the sales practice activity. I was heartened to learn when we discussed this matter last week that Kathleen indicated that at her fund that already occurs to a large extent. In addition, I think there should be some type of insistence on truth in investing. Directors should be satisfied that the disclosure of risks and the description of fund investment objectives are in plain English and easily understandable by the average investor. I think that dovetails with the entire plain English effort that the SEC, under Chairman Levitt's leadership, has initiated. And there should be an insistence, generally, on effective compliance systems. Again, although fund directors are not responsible for overseeing sales practices of bank employees or affiliated broker dealers, they should insist and be satisfied that effective sales practice compliance systems are in place. And I think they do possess the leverage to insist on that. By and large, I would think that both the banks as well as the affiliated broker dealers would certainly be willing in most instances to provide information and inform the directors, if requested, about what systems are in place.
A second area of concern to state regulators in connection with the overall issue of bank-related funds is, as we've already touched upon today, what I'd call functional regulation. There's already been some discussion I think about the fact that many bank advisers who provide advisory services to a number of bank-related funds are not necessarily subject to SEC examinations and audits. And in this regard, I concur with some of the concerns that General Counsel Goldschmid has raised regarding this matter. For example, he has noted that a number of banks have refused to supply records to the SEC when it has initiated investigations or inquiries regarding their investment advisory operations. As Professor Herring noted, although I think bank regulators generally do a very good job, there is a difference in orientation between institutional regulation and functional regulation. And the question I have then is – and I don't know if also this is easily answered, but what role would the board of a bank-related fund that is advised by the bank have in filling this regulatory gap? And the question I'd have for the industry representatives here today, would the board have leverage to encourage the bank, for example, to turn over the supply records to the Securities & Exchange Commission in a situation like that. From the perspective of someone who believes strongly in functional regulation, I would hope that the board would insist that the shareholders, as the watchdog for the shareholders of the fund, that the advisory – that the bank's advisory operations be subject to the same examination and the same rules and the same oversight as other, as other funds are.
Mr. Gonson: Professor Herring, has that ever been brought to the board's attention?
Mr. Herring: No, it has not. Although I do think from my conversations with our fund management group that they have always honored SEC requests for information in this regard.
Mr. Gonson: Mr. Nolen, do you have any experience in this regard? – the SEC seeking information.
Mr. Nolen: No.
Mr. Gonson: Do you think that if these questions arise that management should bring them to the attention of the board, of the funds board?
Mr. Nolen: Every time the SEC appears on the premises, we initial our own inquiry with management as to why, what, and whether there is an exit letter and so on and so on and so forth.
Mr. Gonson: Going to the first part of Mr. Skolnik's presentation, the problem seen often by the securities regulators of securities products being sold on bank premises and the confusion it sometimes results in with customers as to whether FDIC insured, do the – do either of you independent – well, I guess let me ask Professor Herring, does that issue arise? Do you think fund directors question as to whether funds should be sold upstairs, down the street, but not in the bank lobby?
Mr. Herring: I haven't had much experience with that because Bankers Trust is unusual in that it has no retail branches, so it is a whole set of issues that we've been largely spared.
Mr. Gonson: What about Kathy Dennis? Do you have a view?
Ms. Dennis: Well, as I said earlier, our trustees have asked questions about our sales practices and have asked for representatives from the broker dealer side to come and do presentations or have discussions at the board meeting. They understand that they don't have regulator oversight, but they do have what I would call a right to know.
Mr. Gonson: I think now is a good time to shift gears. Thank you very much all of you bank-related people for your very good discussions. We're now going to shift to Diane Ambler, who is going to carry by herself, the question of the variable insurance funds. I might say that there is a certain irony that Diane was sort of noting that her name starts with "A" so she always gets sort of put off at the end. It could be worse, her name could be Zimmer or something like that; but she gets introduced first and then she speaks last. But it will be a highlight.
Ms. Ambler: Well, thank you so much. It's an honor to be here. It was noted to me this morning in the hall that this is actually the kitchen sink panel, but I'm not sure that's the case, because we've all been running through the same theme, which is that the process for the independent board is the same as with any, certainly in the case of the bank-related funds, and now in the case of the insurance products funds, as any mutual fund. But with the insurance products funds, I'm always aware of a certain math anxiety that occurs in a room when anyone mentions the term, variable insurance products, and a lot of people start sliding out the door and looking for other things to do. I'm not sure it's that people so much hate these things, as that they're frightened at the prospect of having to actually understand them. You can all relax. This program is not about variable insurance products, it's about the role of the independent directors and to that extent, I will speak only briefly about the products themselves. But in order to give you some context, I will at least identify how these things work in general, and then we'll get back to the idea of what the role of the independent board is.
Variable products are created by insurance companies. Any cash in the product that's not being used for insurance is held in a separate account of the insurance company and the separate account is an asset pool, basically segregated from the insurance company's general assets. That asset pool is dedicated to the particular variable insurance products. The insurance company and the separate account are heavily regulated under state insurance law, and to that extent the products are involved with state regulation, in every state in which they're offered. So typically, the separate account invests in an underlying mutual fund, and the separate account and the underlying fund are both registered under the '40 Act, and the interests in the variable insurance product, as well as the interests in the mutual fund are registered under the 33 Act. You can see, there are a lot of layers of regulation, already, and I think this is one of the complicating factors that sets people off. The underlying funds can be established by the sponsoring insurance company, which acts as the adviser to the fund, or have an affiliate of the insurance company acting as an adviser, and these funds are dedicated principally to that insurance company's products. It is also common for a public mutual fund or public mutual fund complexes to create funds to be sold through variable insurance products of one or more unaffiliated companies.
For tax reasons, another regulatory overlay: a mutual fund sold directly to the public cannot also be sold there variable insurance products, as a general matter, so fund complexes will replicate or clone their publicly available fund and use this clone fund for variable insurance products. That's the end of the lesson on variable insurance products. When you get right down to it, insurance company dedicated funds and clone funds are both just typical mutual fund, and as the staff said as recently as two years ago, no provision of the 40 Act or the rules thereunder treats underlying funds differently from other mutual funds, which is a relief for everyone. So there is nothing special about these funds that immediately triggers, for the boards, any special concerns or obligations. To be sure, regulation at the product level can be very complex, and in 1966, with the amendments to the '40 Act that were enacted by NISMEA, a lot of changes were made in that complex regulation of the insurance product pricing. It used to be that insurance products had strict regulatory limits on the amount and types of charges that could be imposed on the product. These products were regulated as periodic payment plan certificates.
But that's all been changed with NISMEA, and now the insurance company represents, in its registration statement for the product, that all variable insurance product charges in the aggregate are reasonable, and this includes the fund-level charges. So the insurance company itself goes through a long consideration of what the charges are that are being imposed on the ultimate purchaser, the contract owner. The fund board, then, can take some comfort from the fact that the product is regulated by the Commission and that the insurance company has looked at the whole fee package and found it to be reasonable. The dynamic for a board of a dedicated fund can be a little different than that in a clone fund, a public clone fund. When the adviser is the insurance company or it's affiliate using the variable insurance products, the board may have less practical leverage in considering the advisory agreement. Obviously, the board of the fund will be doing its normal 15(c) review of the advisory agreement.
Also, the board is mindful in review of the advisory agreement that the insurance company imposes additional fees and charges on the product. That product level fee, to the extent that the board gets involved in looking at it, may be the opportunity for some fallout financial benefit, one of the Gartenberg standards, and that's something that may be considered, but often to a limited extent. For the most part, variable insurance products are viewed by underlying funds as a means of distributing the fund shares, and that's principally how they are viewed, particularly when you're talking about a clone fund operation. So that extent, this discussion is more relevant to yesterday's distribution panel. To the boards that consider the distribution issues related to variable insurance products, most of the considerations relate to the fact that these products are very attractive, they provide real value in terms of omnibus accounting and other administrative services, and that value is something that is recognized and considered by the fund board, for the most part.
Most underlying funds do not employ 12(b)(1) plans, but I listened with interest to the distribution panel yesterday, because the concerns raised there about the fund supermarket letter and the scope of 12(b)(1) apply here, as well. The old adage is that insurance products are sold and not bought. One of the unique marketing advantages of variable products is the range of contract owner services provided. Investment companies are hands-on organizations when it comes to their contract owners. So where do you draw the line between distribution and administration in this context, and what kind of quandary does that present to a fund board that has, all along, viewed administrative services as just that, but now may need to consider if those services could be said to have a distribution element? There is one issue that is particular to underlying fund boards that is not presented to public mutual funds, and that is a concept of mixed and shared funding that comes up. It's a Commission-created concept, and it comes up when you have a fund that issues its shares to affiliated and unaffiliated life insurance companies, and it's being used to fund variable annuities, as well as variable life insurance.
The Commission has imposed on fund boards the obligation to monitor for any potential material irreconcilable conflicts in relation to having unaffiliated companies and different types of products. And, as I've mentioned, you have a number of different regulators involved in the pot here. You have the state insurance regulators. You have tax issues, as well as SEC issues, that could relate differently to variable annuities and variable life, and thereby create potentially conflicts for the fund board to the extent they may impact on the manner or types of investments that can be made at the fund level. In my experience, there has been very little that has ever been presented to the board that would raise to the level of a material irreconcilable conflict, and for the most part, that monitoring involves just a brief report at each meeting.
Mr. Gonson: Thank you. You had mentioned, in your discussion, the change by NISMEA, and I guess you alluded briefly to Gartenberg. Let me ask you a question. I guess it has to do with what is sometimes referred to as a double layer of fees. Gartenberg, which was referred to yesterday extensively during the panel on fees and expenses, was a 1982 Second Circuit case, and under the context of Section 36(b), the case said that the adviser manager had to charge a fee that was so disproportionately large it bears no reasonable relationship to the services rendered, which gives enormous, wide latitude. But the change made by NISMEA under new Section 26(e) referred to in your excellent paper now subjects all of the variable insurance product charges, as you said, in the aggregate, to a reasonable standard. Now, reasonableness is a narrower standard than the Gartenberg "so disproportionately large" standard, but you also indicated that you think that this is an issue for the insurance company – that is, is it reasonable – and not for underlying fund board. So I guess this very long question gets down to, what is the responsibility of the underlying fund board when the law says that the aggregate of fees has to be reasonable, and essentially, these are going to be born by the fund shareholders? What do you think is the board's obligation, the underlying fund board's obligation?
Ms. Ambler: The answer may differ if you're talking about a dedicated fund versus a clone fund, because in the dedicated context, the fund board is well aware of the insurance company and the products that the insurance company is having funded through that fund, or by that fund. In a clone fund context, you may have a mutual fund group that is selling to multiple different insurance companies, and supporting a variety of different products, the complexity of which would simply bewilder most people, let along the fund board. That being said, you're absolutely right, that the board is aware that there are fund level charges, and they're interested in the fund level charges. They are certainly interested in the fact of what the ultimate package is that the shareholder is receiving – the contract owner or shareholder, which is, although they are separate accounts, in reality, the shareholder of the fund shares, the contract owner is the beneficial owner of those shares. But, in fact, I think that the boards do not get into the specifics, much as they don't get into the specifics in public funds, where financial planners may impose fees on their services that they provide in connection with the sale of mutual funds. There are a variety of different services that are being provided in connection with the insurance product, and the insurance product fees are intended to compensate for those services, and there are services about which the board really knows nothing, insurance-related charges and what have you.
Mr. Gonson: That, I think, raises a question, then for Mr. Nolen and Professor Herring. You're independent directors. And let's say that you were having to make a decision about whether to offer one of your funds through a variable product. Would you consider it your responsibility as independent fund director to weigh the actual fees and expenses at the insurance company level?
Mr. Nolen: It's not an issue I've ever addressed, and I can't answer it.
Mr. Gonson: Professor Herring, can you?
Mr. Herring: I'm afraid I have the same lack of experience to draw on.
Mr. Gonson: If you had to hypothesize an answer.
(Laughter.)
Mr. Gonson: What might it be?
Mr. Herring: Well, I'm instinctively unhappy with arrangements that tack on a lot of fees, whether they're independent financial advisers or insurance, to shareholders. But, given the structure, I think it's, especially if it's a clone fund, which would be our likely experience, it seems to me to be difficult to reach all the way back to how the product will be layered with other products, and to make a determination that is appropriate.
Mr. Gonson: If you're making hypothetical judgments, what about if your fund were to be offered through another distribution channel, such as a fund supermarket, which let's assume also charged extra fees? I mean, would that be the same issue, or a similar issue?
Ms. Ambler: I'll interrupt and answer your question.
Mr. Gonson: Sure.
Ms. Ambler: Which is, one of the major differences fund supermarkets and variable insurance products is that the insurance product itself is regulated under the '40 Act and interest under the '33 Act. So I think that provides a real comfort to the board, and our boards have been comforted by that, in the sense that 26(c) is a specific statutory provision that relates to all the fees and charges, which, in effect, takes it out of the hands of the board.
Mr. Gonson: Is there a cultural question? Professor Herring, when he spoke about banks, talked about safety and soundness and their desire, generally, to keep things quiet, to avoid a run on the bank. And it's just like the marking-to-market contrast to that with securities regulators. Now, investment companies, of course, also come from a culture quite different from securities people, and there was a time before the court said that these had to be registered, when they weren't, and they've been around a long time. Do you have any views on that, Diane, as to whether there are cultural differences creating problems?
Ms. Ambler: Well, I think over the years there have been. I mean, it's an adjustment for any group, that I think banks are going through now, or are on the tail end of that, and insurance companies went through it a number of years ago, to become accustomed to the new regulatory aspects of the new world they've entered into. And much as was said earlier about banks and the question of how central a role mutual funds may play in a banking organization, at one point, insurance companies faced that same question. When variable insurance products are relatively new, to what extent was the insurance company itself standing behind those products and viewed it as an important aspect of what they were marketing But ultimately, I think insurance companies have become very comfortable and work very closely with the SEC and the regulatory framework here.
Mr. Herring: Well, I think there are some good things about the cultural differences, as well. In looking at our bank-affiliated funds, I think the emphasis that banks inevitably have on risk management of their entire business is a useful context to think about the fund business. Credit risk is one of the core things that all banks need to think about very carefully. I think we as independent trustees draw some satisfaction, that we have the entire credit resources of Bankers' Trust looking at each of our credit risk-sensitive products. We have some funds from Latin America and Southeast Asia that have liquidity that is perhaps a little less than that of the US Treasury markets, and we have devised some tests for figuring out the liquidity of those funds, and we take a very careful look at the pricing to make sure the pricing we're getting is on the mark. Bankers' trust is well know for its risk management system. It is an earlier variant, a more sophisticated one, of value at risk, and they have applied that same discipline to the fund's management. So when we look at a fund, we have a very clear understanding of how much of the performance is attributable to the benchmark, how much is value added by the investment manager. And we're looking at risk-adjusted returns, which I think is a real plus, and comes quite naturally out of the bank culture.
Mr. Gonson: We are hard coming onto the lunch hour. We started a little late, so we're finishing a little late. And there are some of us, such as myself, where I guess my impending digestive processes overtake my cerebrum, or cerebellum – what is it? So I think that we should probably draw to a close. Does anyone wish to have a further word before we do so?
(No response.)
Mr. Gonson: I guess, hearing none, I want to thank the panel very much for the very interesting discussion.
(Applause.)
(Whereupon, at 12:50 p.m., a luncheon recess was taken.)
Top
Enhancing the Effectiveness of Independent Directors
(Part I)
Mr. Goldschmid: Hello. I'm Harvey Goldschmid, general counsel of the SEC. Let me call this session to order. We are focused on enhancing the effectiveness of independent directors. There's a certain amount of de ja vou for at least four members of the panel, I think. We spent most of the 1980s and part of the early '90s talking about corporate governance in the public corporation context, and now we've moved on to investment advisers, investment in mutual funds. I'm going to move right to our speakers, though I'm going to keep throwing in questions as we go, and I'm going to introduce them right before they begin to speak. There is a substantial amount of biographical material in the books you have before you, for those who want to read in detail. Our first speaker is Ron Gilson, who is something of an academic black belt, holding chairs at both Stanford and Columbia. He is truly one of the most accomplished and distinguished scholars we have. He is going to talk about the complexity of the mutual fund director's job, resources of inspiration and regulation for those directors. And Ron, you can take it from here.
Mr. Gilson: We'll see if my accomplishment extends to making this machine work. Law professors and technology is typically not a good match. It's a pleasure to be here. It's not just that the subject is important, but for years I've attended events at which representatives of the SEC spoke, and each time each of them would begin their remarks with a disclaimer. Of course, as soon as they made the disclaimer that, of course, they were speaking for themselves and they weren't speaking on behalf of the SEC, all of us listened very attentively. So for the first time, I actually think I get to make a disclaimer. I'm here in my own capacity. My remarks today mostly reflect my academic life, and in particular, I don't purport to speak on behalf of any of my colleagues on the Benham American Century Board who it would be hard to tell whether they agree with me or not, and I certainly don't intend to speak for the adviser. I'm going to try to essentially lay out what I hope is some analytic structure for talking about mutual fund governance. In the 10 minutes or so that Harvey has allotted me, I want to talk about essentially three things. The first is that the discussion of mutual fund governance is typically confused. The reason why it's confused is that there's a rather consistent failure to distinguish between, on the one hand, corporate governance, and on the other, mutual fund governance, and as I'm going to try to suggest to you, they are quite different things. Essentially, mutual fund governance, I'm going to suggest, is composed of three parts, only one of which is corporate governance in the sense that we normally speak about it or Harvey, Jack, and I dealt with in connection with the ALI. Now, the structure I have in mind looks something like that. That is, the set of relationships that we observe are threefold. We've got corporate governance, the relationship between the shareholders on one hand and the directors on the other; regulatory governance, which reflects the relationship between the SEC and the directors; and finally, contractual governance, which reflects the relationship between the directors and the adviser. Now, I'm not going to say a great deal about the corporate governance element. In a sense, it's the most familiar portion. That is the relationship is fiduciary. It invokes the traditional duty of loyalty and duty of care, and to the extent that there is an issue in this direction that's operating at the moment, it's largely the issue of independence.
With respect to independence, the subject has been reasonably well focused. A nominating committee made up of independent directors makes an enormous amount of sense. The issue of independence with respect to remuneration is present, but in that respect it's no different than the manner in which it presents itself in any other board context. There is an amount of money that can pose a problem. The number of boards seems to me not to pose a problem any more than the number of subsidiaries in an operating company does. The issues of independence seem to me to get posed in much the same way that the ALI corporate governance project conceived them, and is not in this respect peculiar to mutual funds, as very little of the corporate governance relationship. Things begin to get more interesting – and let me use an earlier slide – when we talk about regulatory governance, because there we now begin to talk about the structure, the regulatory structure which the 1940 Act and the regulations adopted by the SEC impose where essentially the directors are the objects of a delegation of enforcement role from the Commission to the directors. We're essentially charged with enforcing a quite detailed set of regulatory apparatus which runs from the quite serious, being clear about the disclosure concerning the fund's fundamental policies in the prospectus, to the quite ridiculous, approving the sub-custodian for the fund in Borneo. It is a structure which is quite different than the traditional corporate governance structure, and let me give you a sense about what that difference looks like. In the traditional corporate setting, directors' standards, directors' behavior is managed, is essentially governed by the duty of care and as a result of the business judgment rule. Most recently, that's been framed by Chancellor Allen in the Caremark case. The board has to operate in good faith. They have to make such inquiry as they see fit. And, quite critically, the level of detail appropriate for such an information system, the review process, is a question of the director's business judgment. Now, what I've juxtaposed to that is an excerpt from the staff of the division of investment management's recent letter on fund supermarkets. And what the staff tells us is that, in light of the importance of the board's role in overseeing the fund's participation in fund supermarkets, staff will closely review the actions taken by boards that participate in the fund supermarkets.
Under the business judgment rule, courts do not second guess the business judgment of independent directors. That's not the standard that's getting reflected here, and it's not necessarily the case that it should be. My point is that this here is simply that the regulatory governance, the relationship between the SEC and the directors with respect to the enforcement of this regulatory regime is an aspect of regulatory governance. It is a mistake to think of it in terms of traditional corporate governance. Now, once you begin to conceive of that relationship, the relationship between the Commission, the SEC on the one hand and the directors on the other is a matter of regulatory rather than corporate governance, some things begin to fall into shape, begin to become clearer, that may have been confused before. A regulatory governance relationship creates mutual obligations, it doesn't just run one way. The problem I'll use to illustrate it is one I think everybody in the room is familiar with, Navellier. It strikes me as a circumstance in which the Commission significantly confused the issue of regulatory governance and the issue of corporate governance. In Navellier, as I understand it, essentially the independent director's position was that the adviser had violated the 1940 Act. They came to the Commission with that problem. That's an essential part of the role that regulatory governance assigns to the directors. Unfortunately, the SEC responded as if this were an issue of corporate governance, and to give you a feel for that response, I just pulled some quotes from various SEC officials out of the newspaper accounts. There's no particular reason to identify the source of them. The newspaper story is there. But basically, they tell a common theme, right? This was a proxy contest. This was corporate governance. The Commission's role is to monitor it closely. We don't step in on either side. The SEC's role is an unbiased umpire. The SEC is a referee. That may be fine if the issue is one of corporate governance. But in this case, the issue wasn't one of corporate governance, it was the structure of the regulatory relationship between the board and the SEC. The SEC didn't have to take a position with respect to the proxy contest, but they did have to take a position with respect to the assertion by the first line enforcers of this regulatory regime that the adviser had violated the act. That's a regulatory governance obligation, not a corporate governance obligation. Straightening that out isn't – how to go about straightening it out isn't very complicated. Once we frame it as regulatory governance, it seems to me the right outcome flows from recognizing that in this regulatory scheme the directors play a direct regulatory role.
When independent directors believe that there has been a violation of the '40 Act by the adviser, when the SEC is given notice that the first line of enforcement folks think there is a problem, the right answer is, as a matter of policy, an investigation ought to be initiated. If the Commission expects the role, expects the director, independent directors to play the role that they've been assigned, then that role has to be taken seriously, and when they do take it seriously, they can't be treated as if this is some matter of corporate governance if one nice thing that could come out of this roundtable is a release which makes that fact clear. It simply announces that if there is an allegation of improper conduct made by the independent directors, the Commission will take it seriously enough to invoke an investigation.
Let me finish up with the last element of governance. I've talked a little bit about corporate governance, a little bit about regulatory governance. And let me finish with the third element, contractual governance. Here the board's role is really, it seems to me, most analogous to the administration of a long-term relational contract. The relationship between the board, the directors, and the adviser isn't fiduciary. There's a contract, a one-year contract and a long- term relationship which the directors are charged to administer on behalf of the shareholders. In that respect, the model, I suppose, is closer, if you will, to a Japanese automobile company managing its contractual relationship with its long-term suppliers. Now, once we become clear that it's a contractual relationship rather than a corporate governance relationship, again, the issue begins to be a little bit more clear. The common formulation that we're used to hearing about directors and fees is that the independent directors discharge their duty by assuring that adviser fees are within a range of reasonableness. That's a corporate governance statement. It's a fair description of the circumstances under which an independent board would be protected against liability by a suit brought by its shareholders. It's not a statement of what the director's responsibility ought to be in connection with managing a contract on behalf of its shareholders. In that respect, as a matter of contractual governance, directors care where within that range of reasonableness the fee falls. In that respect, I come back to the model that a contractual approach suggests. Japanese automobile manufacturers and their long-time suppliers have a long and steady relationship that is based on routinely falling prices and increasing quality. We know something about managing long-term contractual relationships. It doesn't have anything to do with corporate governance. Okay. Let me summarize the points I've tried to get across. To think carefully about this peculiar beast of mutual fund governance, we have to be careful to keep three different things separate. There are three different relationships that the directors are managing. They are managing a corporate governance relationship with respect to their shareholders. They're managing a regulatory governance relationship with respect to the SEC. And they're managing a contractual relationship with respect to their advisers. Each of those are different. They require a different method of analysis. And I suspect the kinds of issues that we're going to be discussing will become a good deal clearer if we keep those three issues straight.
Mr. Goldschmid: Ron, thank you. Stay there for a minute. Do you mean that if the investment advisers make an allegation, it's got to trigger a major investigation, or are you saying just scrutiny –
Mr. Gilson: No, I guess I'm saying two things. First, I'm talking about the independent directors triggering it, rather than the adviser triggering it.
Mr. Goldschmid: I'm sorry.
Mr. Gilson: That's all right.
(Laughter.)
Mr. Gilson: I have in mind, yes – I'm not sure I can buy into the major, because I'm not clear enough about the internal enforcement, the levels of internal enforcement energy to buy the adjective. But yes, I quite seriously mean a serious investigation, and I mean it for two reasons: One is, it's not something that happens very often. That is, if what the point of part of our exercise here is to energize independent directors, to take those regulatory responsibilities seriously, and that is to take them more seriously than just the business judgment rule formulation would take it, then it imposes an obligation on the SEC. They have to take that role seriously, because it's the regulatory scheme that assigns directors this role. And any other way, you're giving two very different messages to the same group of people: "Directors take this seriously, but we don't have to." I don't think a strategy which points both ways is likely to work.
Mr. Goldschmid: Now, in Navellier and Yachtman, I suppose, as recent examples, the directors were also sued and there were proxy fights with issues as to whether the funds could be used, of the mutual fund. Would you do anything there?
Mr. Gilson: Well, I thought with respect to Yachtman, I thought the SEC, in that setting, the SEC moved quickly and effectively in that regard. People learn.
Mr. Goldschmid: Does anyone else want to take a shot at this?
Mr. Phillips: The SEC's failure to act in Navellier was the result of a misperconception. The SEC has a vigorous enforcement program, and when it receives information from a credible source, it acts on that information. And I have clients who will confirm what I'm saying.
(Laughter.)
Mr. Phillips: Here, I think the Commission discounted the credibility of the independent directors because they viewed the independent directors just like they view contestants in a normal industrial proxy or tender offer fight. In those fights, contestants are always running to the Commission and trying to get the Commission to intervene on one side or the other, and they misperceived this battle in Navellier as being a garden variety corporate struggle for control. They did not understand that the resources and the motivations in the context of the Navellier Case was quite different from those motivations and resources in the ordinary industrial proxy case. It was a miss preconception. It was a mistake. And hopefully, Yachtman evidences that the Commission has corrected that miss preconception
Mr. Goldschmid: Thank you, Jack.
Mr. Coffee: The Commission has two different divisions – Enforcement and Market Regulation. I understand the approach of Market Regulation saying that in the case of proxy contests, we're neutral. We're an umpire. The Enforcement Division has its own separate concerns and should not be in the slightest impeded by the market regulation approach of neutrality. If you get information from independent directors that's a hundred times more reliable than the usual sources for early investigations – civil and criminal. Whistleblowers have all kinds of problems. Independent directors are much more reliable.
Mr. Goldschmid: Thank you. Okay, let's move to our next speaker. For our next speaker, Willie Davis, I don't have to invent the black belt. He's all pro and football hall of fame. And that was in another life. After that, he became an enormously successful businessman and entrepreneur. Today's he's president of All Pro Broadcasting which has radio stations in California and Wisconsin, and for our purpose, most importantly serves on the Strong Fund. And Willie is going to give us a sense of how to deal with major issues as an independent director.
Mr. Davis: Chairman Levitt. Using Ron's backdrop of three baskets of responsibilities to be managed, let me very quickly then say, I would like to spend my time describing more or less – five particular questions that come forth: How independent directors should handle relationships with management of major issues; how do you work with management and police them at the same time; how do you evaluate the reliability and sufficiency of information provided to you by management; what are the successful relationships; and how they are achieved; and are there lessons that can be carried over from the practice of public corporations? I want to quickly say that I serve on a number of public corporations, and I will say to you the first Strong Fund meeting I attended, I said, uh-oh, this is a little different.
(Laughter.)
Mr. Davis: And I – to this day, it's a little different. But clearly there is no ambiguity or questions about independent directors. They have the overall responsibility of supervising fund activities. Their role is to act as watch dogs for fund shareholders to ensure the fund is run in the shareholders' best interest while maintaining a good working relationship with management. Now, there's nothing wrong with that. You know, I don't believe that good independent corporate government has to be confrontational. It might become confrontational. But it doesn't necessarily need to be. At Strong Fund the directors have worked very hard to create an atmosphere of trust between the management and the directors. And, frankly, I personally believe in four important questions invariably in dealing with whatever comes before us: is it legal; is it ethical; is it good business; and is it in the shareholders' best interest? If I can find reasonable responses to those four questions, typically I am pretty comfortable moving forward. And I think that how you carry out this important role is equally as important. You obviously need access to information. Directors should have continuous relevant information. And directors should not just limit it to board meetings. There should be communication on an ongoing basis. And I assure you, it is at Strong Fund – mailings, telephone calls, and of late, even the Web site. Even though I am not technologically that advance, I do have help to the extent that I get the information. But I think the important thing is the Strong Fund provides the information, and that is something that directors insist upon. And I've heard a lot at this conference about plain English. I assure you that we have made that well known as Strong Fund, we would all appreciate plain English. The other thing we insist upon is access to people. Our regular meetings with portfolio managers and other senior advisory personnel is absolutely something we demand. We get to know them individually. We spend extra time with significant new hires, and particularly the portfolio managers. We get to know the investment philosophy of these managers. And I can assure you that that is important. I would like to cite an example where we had a fund that was not being – was not doing well, and in our opinion was not being managed well. We presented this to management and nothing happened. We presented it to management again, and nothing happened. And I think the third time we presented it, they realized we were serious. And pretty soon – I don't know – the fund got better, the manager got better, and we understood each other. And I would say it's very important that you stay on some of these things until you do get the result that you're looking for.
We also established – and with approval right from the start, we have the ability to call the adviser personnel directly. And I think this is something we feel like as long as the process is open, at least we have that opportunity. I think the area the directors more or less should insist upon is to understand the advisers' business, not just the regular fund business. But many times the non fund business also. I think when you're doing a good job as an independent director you are indeed kicking the tires. You know how they service the shareholders, how they trade securities, how they monitor quality, and indeed have on site visitations to see what and experience what I call real time, not something that somehow they report to you just in presentation. But we actually visit sites and see for ourselves that this is going on. I would say that to the extent then that those particular things are approached, typically what we realize we need to be as directors are well prepared. We need to be detail oriented in terms of all the oversight we perform. And we need to be open ourselves to continuous learning. And I think that the main thing is for directors and the advisers is to keep open and clear lines of communication. I think my final thing I would like to – one of the things that I truly believe like all of the things – these things possibly are not on our screen today, but I think they will be in the future. I think the questions of how we include more diversity in this industry, how we handle social issues, is more and more going to be on our screen. And I think that almost it's to the point of, is there a responsibility to give something back in these areas. I think these are all things that we have not been faced with in a particular issue way. But I, indeed, see them on the screen. Thank you.
Mr. Goldschmid: Thanks, Willie. Question for you, have the Strong Funds picked up some of the techniques used for the traditional public corporation, separate meetings of the independent directors, of the director, separation of the chairman from the CEO? That kind of thing, to enhance the effectiveness and independence of the outside or the independent directors?
Mr. Davis: We clearly have incorporated some of those. We have some private meetings with just the directors alone. We have obviously those same type of meetings with the accounting firm. And while we did not officially appoint a lead director, we have someone who anointed himself.
(Laughter.)
Mr. Davis: So we, in fact, have a lead director through the process.
Mr. Goldschmid: Now, one other question along the line – and Ron mentioned this and you mentioned it – the difference between the mutual fund board and the traditional public board. A friend of mine who recently began serving – and served on a number of public corporation boards and recently began serving on a mutual board remarked at the difference but in a critical – at the SEC on some level for the regulatory governance. There was too much – he didn't put it this way – but Mickey Mouse was what he meant – too many trivial things the board of a mutual fund had to do. Do you feel that way?
Mr. Davis: Well, I think there's a constant discussion at Strong about – you know, we almost sometimes seem to have a fund a month. And kind of, is this really needed? Is this the same as something we already have out there as a product? And I think we have raised the bar on that kind of consideration, as to when another fund or when another product is necessary to the extent that we asked the adviser to justify. I think the management at Strong for the most part really do come before us with substantive issues. I realize – and I think they realize over time – that we won't be trivialized with things that shouldn't come.
Mr. Goldschmid: Paul, you had –
Commissioner Carey: Mr. Davis, I would just like to ask you, in your experience is there a natural tension that occurs when you conflict the need to have trust and good working relationship with management and the watch dog – the skepticism that the watch dog role creates?
Mr. Davis: Oh, I think there are moments when – required of not agreeing and not absolutely able to bring closure at the time. But I would say that – I would think on our board, we have probably some of more tougher minded individuals. And, you know, it's almost like you asked me to serve, if you didn't want my opinion, you probably shouldn't have asked me. And I don't think we're easily intimidated.
(Laughter.)
Mr. Davis: So you really get this sense that they kind of know when you're saying, yes, and mean it, no, and mean it. And you kind of understand that with them. And the contentious moments are there for a moment, but we usually find a way to get around them.
Commissioner Unger: Maybe you're not the average independent director.
(Laughter.)
Mr. Davis: Well, I thought so.
Commissioner Unger: But you seem like one that every board should have. What is, you think, the single biggest challenge that you face?
Mr. Davis: I think to remain very current and knowledgeable about what is going on to the extent that you can make the proper decisions and the right decisions as it relates to the shareholders, and at the same time allow yourself to understand management and the business process at the same time.
Commissioner Unger: Using those four principles that you mentioned earlier – legal, ethical – what was the other two? It's good for investors?
Mr. Davis: Yes, yes.
Commissioner Unger: And was that the order that you make those considerations?
Mr. Davis: Well, sometimes it's the nature of what is before me. If it's something that I don't have a great legal concern about, probably as much, then probably the shareholder interest – it probably jumps to the top of the list.
Mr. Goldschmid: Mr. Chairman.
Chairman Levitt: Unfortunately, Ron, I didn't have the opportunity to hear your comparison of the responsibilities of members of corporate boards and investment company boards. I've never served on an investment company board. But I've served on lots of corporate boards. And I would think that there is a tendency on the part of investment company boards to be more accepting of the way things are going than on corporate boards. Maybe that's because of the proliferation of litigation in the corporate world. Maybe it's because so much of what goes on in an investment company is a sense – well, it's almost like serving on a stock exchange board where I found the directors and the governors tended to be accepting of management because they were dealing in something that they had had no life's experience with. But I – maybe you told them just the opposite, and I'm curious to know about that.
Mr. Gilson: Well, I guess, my – speaking normality rather than descriptively – that is I can describe matters for the board that I participate on but not more generally, I guess I think it cuts the other way. In the sense that the relationship between an investment company board and the adviser is a contractual relationship. That is we have an obligation to manage a relationship both as to quality of service, quality of the size of the fee in the same way that any – any large business manages a relationship with an important supplier. That's not – at least the way I think of it – that's not a hands-off relationship. It's not a governance relationship. Indeed, it's one – in my own view it's the most important thing that investment company directors do. But it's one in which you're managing a set of relationships where on the one hand there is – there is a certain zero-sum character to it. That is if fees go down, it works to the benefit of the shareholders. It comes out of managers' pockets. On the other hand, if the relationship works well, there's the potential for everybody to gain. But that's – it seems to me – that's a more hands-on relationship because of its contractual nature than I think is likely the case in a traditional board where both the board and the – both the board and management absent particular circumstances really are on the same side of the issue.
Chairman Levitt: That's probably the single most important judgment a director of an investment company ever has to make. And I guess, the analogy would be in the hiring and firing of the CEO of a corporation. But corporate boards tend to concern themselves with compensation issues, with methods of financing of new products, of – you know, a much broader kinds of considerations. And I wonder whether putting aside the all-important question of affirming the decision to hire a manager, how else would you analogize these two?
Mr. Gilson: There's one area where the analogy, it seems to me where it works quite well, and that is the relationship between the fund's shareholders and the independent directors. In that respect, the independent directors have essentially the same relationship to their shareholders that one would find in a traditional corporation. The place where – the place where we begin to diverge is the group of people who essentially play the management role in the traditional corporation you're referring to are essentially an arms-length contractual relationship in the Investment Company Act. The second difference, frankly, is the role of the Commission because the directors have one additional relationship and that is they operate essentially as enforcement agents for the Commission, an important role, but it also conflicts in a sense.
Chairman Levitt: Let me ask you this question. I have – my experience tells me that the caliber of a board, its willingness to accept standards of independence is very often a function of the character and personality of the CEO. With a weak or an insecure CEO, it's very infrequent that you find a strong and independent board. And the best boards generally partner with a very strong, self- confident CEO.
Mr. Gilson: I think that's certainly right. I think there are things that one can do to try to create a structure which deals with the unfortunate circumstance where that relationship isn't there. So, for example, there are things that one can do to try to create a structure which deals with the unfortunate circumstance where that relationship isn't there. So, for example, it seems to me quite – I would view as quite important a nominating committee composed solely of independent directors because while it won't entirely overcome the absence of the kind of relationship with the adviser that's analogous to the one you described of the CEO, it does provide a mechanism by which the independent directors can maintain a quality of the board membership even in those circumstances in which the adviser may prefer a less independent group.
Mr. Davis: I have the sense, though, that the landscape is changing considerably. Over the last 15 years, I surely have seen corporations really implement far more governance and I think if you remove maybe a little bit of structure difference, I think the bottom line, kind of how you get at results today, is coming closer than I have ever seen it. And I would say activist groups and a few jocks from other places now have more director asking tough questions of the CEO and all of his management. And I think that's good.
Mr. Goldschmid: I was thinking about that. When I began teaching which goes back longer than I care to remember in 1970, the empirical evidence on the public board was that directors were spending about 30 or 40 hours on the job. Today, with all the pressures that have built, we know the figures run over 150 hours. Willie, I take it you think that boards of mutual funds are moving in the same direction or are they back somewhere in terms of activity and, you know, scrutiny and really dealing with the investment advisory and other issues.
Mr. Davis: Well, I hesitate to speak, I'm probably not as knowledgeable as some here, but I would say clearly in my five years I've seen more issues addressed than I would have expected to have addressed either place, be it corporate or in the funds. I do see a change in what is taking place.
Mr. Phillips: I have got to take issue in the assumption underlying your question that the funds, mutual fund boards are playing catch-up with industrial boards. I think in significant part thanks to the 40 Act, mutual fund governance and oversight of management is stronger, generally stronger than in the industrial world, and the industrial world is playing catch-up with the fund world.
Mr. Goldschmid: Dick, let me push you on that one. If I'm a director on a public board and we want to fire and we have enough votes to fire the CEO, we do it. What happens in the mutual fund area?
Mr. Phillips: In the mutual fund area, it's more subtle than that.
(Laughter.)
Mr. Phillips: The CEO of a particular fund, okay, in which a particular group of shareholders are interested in is the portfolio manager and the independent directors have enormous influence in the disposal of the portfolio manager. One note of commentary on the conference at least yesterday when I was here all day was there was very little talk about what interests investors the most and what is most important to the independent directors. And that's the investment performance of the fund. Is the portfolio manager doing a good job? Is the investment manager, the organization, giving that portfolio manager the kind of support that he needs, particularly in view of the growth of many funds. Those are issues that good boards in the fund industry concern themselves very greatly and they have enormous influence both on the choice of a portfolio manager, if in fact – not the choice of a portfolio manager, but the removal of a portfolio manager if, in fact, the performance is poor, and the pressure on the manager of the investment management organization to provide the support that a portfolio manager needs with growth of the fund and the increasing complexity of the investment process. And that's where the independent director should and does spend a good portion of its time. Ron's description of the three types of responsibilities of a mutual fund director is a very helpful one. They have got regulatory responsibilities, because the Commission tends to impose regulatory responsibilities on the directors. That's not what the director thinks is most important. The director looks at the fairness of a deal, but he doesn't – doesn't concern himself ordinarily whether that particular transaction requires an exemptive application from the Commission. He looks at the essential fairness of the deal and not the compliance with the regulatory niceties. And by foisting regulatory responsibilities on directors to a significant extent, there's a disconnect between what a director thinks is important and what the Commission thinks is important. And that, I think, is responsible for a fair amount of the criticism of directors in my view, it reflects a disagreement, if you will, an honest disagreement as to what the priorities of the independent director should be.
Mr. Goldschmid: Jack, it's time we get to you. Jack Coffee is another academic black-belt type, distinguished, mentally productive, talented on every level. The one difference with Ron is we don't share Jack with Stanford. We, wearing my old Columbia hat, I guess, Jack can talk about conflicts in the mutual fund area.
Mr. Coffee: What I want to do is see if I can establish some continuity with what Ron has said on the theoretical level, what Willie Davis has said on the more practical level and with some comments that Dick Phillips has just made about the relative role of conflicts. And I think I agree with much of what they said, but I have some disagreement with each of them. Ron gave us this valuable taxonomic model that said there are these three forces. I want to add one force. One force I think is very different in the context of investment companies applies very differently and basically brings an essential trade-off. That is, investment companies operate in an extremely intensely competitive capital marketplace. Very few public or industrial companies face the same level of competition in the capital markets where consumer sovereignty really is the norm. That is, an open-ended fund can see their capital withdrawn virtually overnight if they don't satisfy the consumer. Now, what does that mean? It doesn't answer all problems by any means at all; but the reality of a strong capital market and the reality of a low-cost exit option for investors implies this trade-off that I think the SEC has to focus on. Some things the market does better than even the most independent board, and some things independent board does much better than the capital market. Thus, I think it would be a mistake to try to encourage activism for the sake of encouraging activism by independent directors. You want to focus on where their activism is most needed. Where do I think it's most needed? Well, I would see a spectrum that begins on one side with things like investment policies and strategies where I don't think the board needs to be encouraged to be significantly more activist in reviewing the portfolio managers investment strategies. I'm not saying that they should duck it and not monitor it, but it's not where we most need activism. Because changes there disrupt investor expectations and they can lead to serious conflicts where the board may not have the better institutional competence. At the other end of the spectrum, we come to conflicts of interest which is what I'm going to be talking about. There, they tend to be invisible and they tend to be something that the market can't correct very well, and this is where a properly armed, properly enhanced board I think can contribute greatly.
But I immediately expect a response I've heard many times when I've had this discussion before. And this response which was a little bit there, although I don't want to parrot it in any of what Dick is saying and that is that conflicts don't matter much, only the rate of return does. I think there are – I'm not saying Dick said that, but I have heard others say that in even blunter terms. I think there were three responses that the SEC should agree with in this area. First, conflicts inevitably grow and can easily corrupt the overall governance frame work and thus invisibly erode the rate of return. Being a little bit conflicted and a little bit pregnant are very similar concepts. Let me give one simple example. In 1998, the SEC Enforcement Division in a still pending proceeding against Monetta Financial Services, and I happen to have served as an expert witness in this case, alleged that Monetta Financial, an investment adviser, had engaged in a long-standing practice of allocating very profitable hot stock IPO allocations to its outside directors and to its private advisory clients in preference to its mutual funds. Yet, these IPO allocations came almost exclusively because of brokerage commissions that were generated virtually exclusively by the two mutual funds, both of which were very ready to accept these opportunities. Now, look what happens in this kind of situation. There is not just one injury, there's a series of injuries and I think there is a domino effect between them. First of all, the fund loses very attractive, very, very profitable hot stock allocations which were given to the fund for brokerage commissions because they were known to be very profitable. Worse, the second injury is the underwriters and the brokers who allocate these ideal allocations to the investment adviser are going to expect brokerage commissions in return, and they're going to feel they don't have to compete at the level of price quite as intensely because they have been paying for their business with hot stock allocations and, thus, there is an invisible injury there in the cost the funds will incur. Finally, third, the outside directors have been compromised. They have been compromised because if they are accepting these allocations, they are pretty much stopped from criticizing the fund when – the investment adviser, that is, when it begins to allocates similar hot stock allocations to new clients in order to win their business keeping the fund as more or less captive. These problems are not limited to any one context. I could talk about them if we had time in a variety of other contexts. That's the first point. These conflicts tend to grow and tend to reach out and tend to affect the rate of return sooner or later. The second point I guess is that the mutual fund business has tremendously expanded over the last 10 years and it's expanded in areas that are really not represented in this room today. I think we have the old established players here; but as we have gone up thousands of new funds a year, there are a lot of smaller funds with a lot less governance skills, a lot less tradition, a lot less knowledge and background. And in those areas, unless there are clearer guidelines for how to enhance the independent director, I think we have an inadequate system for those smaller funds.
Lastly, the importance of conflicts I think is going to be greater in the future because it's a fairly safe prediction that just as we have seen waves of consolidations sweep through the banking and insurance and finance industries, we're probably going to see a similar wave of consolidation move through investment advisers and mutual funds. And as that happens there is a critical decision, a decision in mergers and fund consolidations that are just as important as the decisions over whether or not to replace the investment adviser. In fact, the investment adviser is gone, the question is: What do you do? Do you sit there passively or do you auction off and try to find the best possible successor? Now, getting specific, what can we do to enhance the level of monitoring at the independent director level? Here, I want to look at the experience several of us have had from general corporate governance and say: What carries over? What can be applied to this context? I would say that we should analogize the independent directors of an investment company to a committee of independent directors of a public corporation, the kind of committee that is used in several well known contexts. Typically to negotiate a merger with a dominating parent, a 51 percent parent; you have to have the independent directors negotiate with them over the terms of the merger. We also use this committee to investigate serious charges of misconduct by senior management. Those are two areas, where there's been an awful lot of experience. And what have we learned? I would say that the central lesson from corporate governance generally is that independent directors can function well as a committee if and probably only if they have the effective assistance of a truly independent legal counsel who does not generally represent the investment adviser and who does not have any other conflict. I will come to what I mean by that in a little bit more detail. What I have just said is probably generally conceded. There are very few lawyers today who will still maintain that one counsel can represent both the investment adviser and the independent directors. What is the real issue today is whether given that you have to have two counsels, whether one of those counsels represents both the adviser and the fund with the other counsel representing only the independent directors, or whether you have one counsel representing the independent directors and the fund and the other counsel representing the investment adviser.
I believe there is a strong argument that we want the counsel who's independent representing only the independent directors. Because if he represents both the directors and the fund, we have the following problem. The fund is really going to be the management of the fund, the president of the fund who is going to be the person that that lawyer will be in day-to-day contact with, who will have the phone calls with, who will get the marching orders, who will get the business from. And if we say that, then that lawyer is going to identify with the president of the fund, the manager of the fund as his real client. I think it is much better to try to recognize that the investment adviser and the fund are basically one and the same. They are management. The independent directors should have their own counsel which they choose and they do not accept a nominee necessarily suggested to them by the investment adviser. Okay. That's my first specific suggestion. Second specific suggestion and I'll get much quicker now. When you look at the recent and somewhat unhappy history of fund governance where it's not done well in cases like Monetta, Parnassus, several other SEC enforcement proceedings, you tend to find a common denominator. There were only maybe two independent directors on the fund's board. It was a very small board of two independent directors. That may not be enough critical mass. Yes, I know it's expensive if you have more independent directors, but you may need a mass of three or four experienced directors before they become an equal negotiator with the investment adviser. It is expensive, but there is a Lipper financial study that shows that the entire cost of independent directors to the entire industry comes to less than one-half of one basis point. Remember that a basis point is one one-hundredth of one percent. One half of that is a small amount in terms of what I think the service independent directors do provide. Okay. Point 3. Everyone has said this, but I'll just say it very quickly. Independent directors as a committee need to be proactive. Rather than receiving information, they have to ask for information. But how do you do that?
That's the real role of independent counsel. If you look at independent committees in merger negotiations, the best ones write letters to the parent company at the outset saying, "Give us all the following information." They don't wait for soft dollar disclosures. They say, "We want the following contracts. We want anything that bears on the following questions. We send out a fishing net and we'll take everything that comes in and we'll decide what is material to present to the board." I think that kind of proactive approach does get a much more enhanced effective independent director committee. Next. Point 4: The SEC needs to expand on its W.R. Grace decision. W.R. Grace, as you know, says that directors may rely upon company procedures for determining when disclosure is required. And they may do so only if the director has a "reasonable basis for believing that these procedures have resulted in full consideration of the issues." Now, what does that mean in the mutual fund context? It is too generalized, too global in the form of the W.R. Grace decision to be specific guidance to the independent director. But what does a reasonable basis for believing there's been full consideration? It may require an independent director, an independent counsel. It may require independent nominating committee. It may require various other proactive regularized procedures. But I think guidance in that area is clearly within the SEC's mission. They have already issued the W.R. Grace opinion and making it specifically applicable and explaining how it might apply to the context of independent directors seems to me to be the logical next step. Okay. Two other points quickly. One not so quickly. The one that's really quickly: Independent nominating committees, yes, we should have them. We already have them for 12b-1 funds. There is no great problem in having them. They make a difference over time, so self- nominating independent directors strikes me as one of the prerequisites quite possibly for a reasonable basis under Grace. Last point, the most controversial point and I saved it for last. I don't have a radical solution. This is the Strougo problem. Can you really be independent if you're serving as the independent director on 30 or 40 different boards for a family of funds?
I think we have to find a compromise answer here. I don't think an all or nothing answer is going to work. Let me put it in this very simple hypothetical. Let's suppose independent adviser has five funds, a closed-end company fund, specializing in Russian securities; a municipal bond fund in a very specialized world of municipal bonds; a money market fund mainly concerned with not breaking the dollar; a go-go aggressive common stock fund and maybe some kind of derivatives securities fund. Those are five very different entities. No board, no director is optimal for all five of those boards. When we have the Strougo family of funds approach, we're using the same directors across a wide variety of context. At the same time, I am not suggesting that a director can only serve on 1, 2, or 3 boards. What I would suggest is the compromise here that should be looked into is the possibility of compromising directors who serve across the broad range of funds for one investment adviser with specialty directors. For example, in the context of the closed-end company fund, you may have always had four independent directors on this board. But maybe two or three of them can come, maybe two of them should come from the regular warehouse of independent directors that this investment adviser maintains. Maybe another two should be specialists who, believe it or not, can actually read Russian. I can see some reasons why that's important for a country fund that specializes only in Russian securities. I think you have to recognize the argument for specialization if you are taking independent directors seriously. And different kinds of funds need different kinds of independent directors. I think that is possible to follow that kind of approach and build it into a W.R. Grace kind of model of what is a reasonable basis for consideration of issues without challenging state corporate governance. I am not arguing that Strougo should be either accepted at the judicial level or the legislation should override the new Maryland law. I'm saying that there is a way to blend specialization in with the idea of the economies of scale and scope that you get from having a large collective family of directors.
Mr. Phillips: I'm puzzled. I'm glad you brought that last point up, because until you got there, I had found nothing to disagree with.
Mr. Coffee: I would truly be worried if that were the case.
Mr. Goldschmid: If you weren't looking at Dick's face as Jack was speaking, you were missing something.
(Laughter.)
Mr. Phillips: I don't understand how you can argue that the focal point of the independent directors should be on conflicts of interest, and I agree with you, and then say, "Gee, if they're on the board of a Russian fund, they ought to be able to speak Russian." How does Russian, the Russian language, help in the resolution of conflicts of interest?
Mr. Coffee: I don't think you really know what's going on in that country and know what kinds of conflicts of interest may exist behind the scenes in Russia unless you know a little about the context. I'm not suggesting that all directors should be Russian, or should speak Russian. I was saying that out of a 10-member board, if you have three independent directors, you have five independent directors, one or two of them might have to know something about the specific context.
Mr. Phillips: I would agree with you that if you consider that the primary function of a director is to monitor investment performance, it would be helpful for a director to speak Russian. But if, as you say, their primary function is conflicts of interest, I'm just puzzled by that kind of talk.
Mr. Gilson: It's always a problem to disagree with Jack, but here I just want to try to – I think Jack suddenly sort of changed gears as he ended his comments. Strougo raises, as Jack properly suggested, conflict of interest problems. That is, the circumstances in which independent directors are or are not compromised by the number of boards or the amount of money they had. That's one issue, and it's an important issue. My own inclination is, it's not the number of boards. It is possible that an amount of money may cause me to run into a conflict, but the number of boards doesn't do it.
Chairman Levitt: Do you really believe that a director who is paid $140,000 a year may be less independent than one who is paid $30,000?
Mr. Gilson: Here, I'm going to revert back to the role I had with the American Law Institute. I can't answer that question if all you tell me is the $140,000. If you tell me that $140,000 of that director's income comes from being a director and $25,000 of his income comes from teaching kindergarten, so that that directorship represents 7/8th's of his income, I've got a problem.
Chairman Levitt: I don't know. I guess I disagree with you on that. My experience has been – I mean, I've seen directors paid very little who didn't appear to be at all independent and those paid a great deal are among the most effective and independent directors I've known. I'm not sure that we really can pursue that analogy.
Mr. Phillips: Is it the amount of money or who does the paying, and who decides how much pay the director is going to get? If those decisions are in the hands of the independent directors, one has difficulty understanding how it affects their independence vis-୶is the adviser.
Commissioner Unger: Here's another question for you guys. While you're considering other elements of independence, how about the length of tenure an independent director serves? Does there come a point in time when you have served a number of years you are no longer independent, because you've become so intertwined with the management of the company?
Mr. Coffee: I think that's a very good point, but I would call that a best practices point. I don't think you can really regulate that, but I think you could point to best practices, that there is an age or a duration after which it would require some special explanation.
Chairman Levitt: I'll bet the turnover on investment company boards, my guess would be, is a lot less than on corporate boards. Investment company directors tend to stay for long periods of time. And does that compromise independence?
Commissioner Unger: What should be the best practices?
Mr. Coffee: Let me see if I first can answer both Ron and Dick before I take all everyone else is piling on here.
(Laughter.)
Mr. Coffee: I wanted to make a very simple point to Dick, that if you have been to Russia, as I have been, and looked at their capital markets, you see conflicts of interest everywhere, under the table, every possible scene. And I don't think you can really understand just what might be going in buying Russian securities without some real knowledge of the local context. So it's not inconsistent for me to say the focus of independent directors is on monitoring conflicts, and you need to know the local context. With regard to Ron, his point about materiality is very good, but there's a bigger problem with what Ron is saying that does make the number of boards you serve on relevant. If you serve on 40 boards for one investment adviser, you begin to see yourself as, in effect, the director for the parent corporation that has 47 subsidiaries. Once you start to do that, once you start saying, "I'm working this on an across-the-board basis," you tend necessarily to trade off the interests of Fund 1 with Fund 16. You may say: "We've had a terrific year on 32 of these funds, therefore, we should keep the investment adviser in place, even though at two of these funds, we've had a terrible year." And that subordinates the interest of the investors in the two funds that have lost money to the much greater number of funds where the shareholders have made money. Those shareholders in those two funds that have lost money would do better if they had a more independent board that wasn't engaging in that kind of global tradeoff. That, I think, is the problem, and I think it occurs anytime you have some level of identity with the investment adviser.
Mr. Goldschmid: Paul Carey, you get the last word on this one.
Commissioner Unger: He didn't answer.
Commissioner Carey: The first conflict that you raised, outside directors receiving stock in hot deals through an allocation by the fund manager, is that the kind of thing that could be addressed by a set of best practices to effectively prohibit outside directors from receiving?
Mr. Coffee: I think it really is prohibited today, which is why the Enforcement Division that brought this proceeding – I think that the problem is, it was so low visibility that disclosure rules don't pick it up. You need directors on the scene, an independent counsel, and you need directors who not only monitor the investment adviser, but who monitor each other, which is why again, I think you need a strong counsel who tries to establish what the ground rules are.
Mr. Ogg: The independent counsel point is important in that respect, because an independent counsel would never have let that go through.
Mr. Goldschmid: Leslie Ogg, you've been wonderfully patient.
Mr. Ogg: The problem I have is that you've all been piling up on top of my topic. I've got to come out from underneath this pile.
(Laughter.)
Mr. Ogg: It's nice to be able to come out of this discussion agreeing with the Chairman. Clearly, as we've seen over the last day-and-a- half, being an independent director in this industry is a profession. It's not a casual occupation. It's not a retirement annuity. It's a business that really requires a lot of attention. One of the things that has been so impressive about the presentations by the independent directors is how evident it is that they don't just get a board book and read through the book and show up at meetings. These people spend an awfully lot of time thinking about their responsibilities, understanding the industry. They are truly engaged, very passionate individuals. And maybe the answer to the whole thing is to agree with Commissioner Unger. We'll just clone this group of directors and we'll put them on all the boards. But I think somewhere in the reading, there's about 1,500 independent directors in this industry, and one of the things that we need to do is to understand how all 1,500 of these persons can serve effectively as part of their role. My job, basically, is to talk about the service providers, and for my purpose, the service providers are all of those persons who provide information and support to the independent directors, and generally excludes the primary service provider. In most cases, that's going to be the investment manager. There are some variations in the structures, but for now, let's just say everyone other than the primary service provider will be referred to as a service provider. What is their role? Their role is to protect the independent directors and to further interest of fund shareholders. There seems to be a perception that independent directors have only a self-interest and they are beholden to management. I truly disagree. I mean, I've met a number of independent directors. They're all capable individuals. They desire to do a good job. So if that's the perception, what are the problems here? Clearly, they have a legitimate right to be concerned about their personal wealth. They also have a right to be compensated appropriately.
So let's look at why there may be some perception. Do independent directors not understand their responsibilities? Do they not have the right tools? Do they not know how to use the tools they have? And do they not know how to organize themselves in order to effectively use those tools? Well, let's start out. One solution is structure. Structure is a way – we've heard various discussions of committees, of operating companies, how they've structure themselves. We've talked about how service providers, independent counsel, all of the other service providers, which I will mention in a minute, get into this. But let's start out with the structure of the boards themselves. There are certain things that independent directors surely need to do, and clearly one of them is to set their own compensation. They pay themselves. Now, when you're on multiple boards, whether it's five funds or 55 funds or 195 funds, as the director, you set your compensation on a fund-by-fund basis, and you have to understand that most issues that are presented affect all of the funds; some issues will only affect some of the funds; and there may be a few issues in which the interest of one group of fund shareholders may differ from the other. You are paid. You have however many masters you have, and you must serve those masters, and you must recognize those kind of issues as they are presented, and address them. Once you have designed a structure – and, you know, the structures can be very demonstrative. So if you are paying your own compensation, if you control your term in office, and then you set our own agenda, you can measure how effective that structure is. So while you talk about independence as a concept, and you talk about independence as a legal requirement, clearly being an interested person or a non-interested person is just a starting point. The legal definition is not what we're talking about here. What we're trying to do is to create a structure that creates operative independence. That doesn't mean it's hostile to management. That doesn't mean that it's conflicts of interest with management. What you are trying to do is address those situations where there needs to be an opportunity for a subset, in this case, of directors to be able to, if they get the relevant facts, to analyze those facts in relationship to their responsibilities and come to an informed decision. Well, what are the processes that would naturally follow in a situation like this?
Well, clearly the service providers, the persons like the independent counsel, the independent auditors, the administrators, and a lot of times it's custodians, it's pricing services – there's a whole lot of service providers out there, there's a whole lot of service providers here in this audience who have spent two days of their time listening to what is being discussed so that they can take back to their clients some of the information. Now, these service providers may speak Russian. If you have to have a Russian expert and you, as the board members, recognize your need to have this expertise, then use a service provider. That's what is important in the whole process. And sometimes I hear, "But we don't have any money." Goodness gracious, you're the independent directors. You control all the contractual relationships, including hiring all the service providers that you need to conduct your fiduciary responsibilities. Failure to use the fund assets to hire the service providers that you need would be inconsistent with your responsibilities. So certainly you have the assets available if you need somebody. What do service providers basically do? We've talked about preparing the agendas. We know that a vast amount of data is not information. You can't operate on vast amounts of data. You want to make sure that you have adequate controls of the topics to be discussed. You may want somebody to digest the information for you, somebody that's different from the person that's providing you the information. So there's an inherent bias in every presentation. Whatever side of the street this is being made, the efforts to minimize the bias by the boards are what is going to make them operatively independent in their work. So then you may need the service provider to explain to you the significance of what you hear. A presentation may give you a tad of data about a particular event, but if you don't understand this industry, if you're not steeped in this lore, you may not understand the significance of that presentation. Very often, it's not intentional deception. It's just that the primary service provider spends so much time thinking about the whole process that the presentation often leads to a presentation that is trying to achieve the conclusion. Well, the service providers can also make the record. It's a record from your point of view as the independent directors, and it also, with the use of service providers, provides for a follow-up to questions.
As was pointed out earlier, directors often ask extremely intelligent questions, and off the top of the head, the answers are not often too informative. One of the things you want to do is make sure that those good questions are not forgotten. But why am I here? And let me say that the IDS board is not unique. They just use service providers effectively, I believe. They use service providers to do some cost allocations. They use service providers like myself, who hire on on a contractual basis to do many of the things that I say – prepare the agendas, make the records, ensure follow-up. They use service providers like conferences or consultants to have off-site meetings to get better informed about the industry. So these are opportunities that are available, regardless of size of the fund. In fact, I know many of the service providers sitting in this audience. Many of them spend a lot of time on pro bono work, or awful close to pro bono work, to try to help the small companies get up and running. What has to happen, though, is that we have to somehow make sure that all of those companies, somewhere on that board, there are directors who understand the availability of the resources that they have. Education, very important. Very important that information like this conference will get into the hands of 1,500 individuals. How do we do that? Well, there are several methods of communications and several ways that might be explored that we've talked about. And I think my time is up, so I won't say what I think the SEC's role is at this point.
(Laughter.)
Mr. Goldschmid: We'll get to that. But I do want to make sure we get Dick Phillips in. Dick is senior partner at the Washington office of Kirkpatrick and Lockhart. If you heard Mike Eisenberg introduce all of this during his panel, during the first day, Dick was there at the beginning of many of the mutual fund rules. He's one of the wisest men I know, and given him a roving mandate to correct anyone he likes.
Mr. Phillips: I've already taken exception to the one thing that's been said that I disagree with. I do agree with most of what has been said. I particularly agree with Jack, when he says that the focal point of the independent directors is conflicts of interest. Conflicts of interest in the investment company setting with an external management structure are somewhat more widespread than in the ordinary corporate structure. The reason for that is that the investment company and the investment adviser, they are in somewhat different businesses with different objectives. The independent directors have a very concrete mission. I don't think it's well expressed by saying they're watchdogs.
I think that their mission is to impose on the investment adviser a discipline, a discipline whereby the investment adviser, when he comes forth with proposals to enhance his business, has to test the viability of that proposal by asking whether it is in the interests of shareholders, whether there are benefits to the shareholders of the fund, if not benefits, at least is it harmful to the existing shareholders. That discipline is very peculiar to the ordinary red-blooded American businessman, and an investment adviser to a mutual fund falls in that category. The investment adviser tends to look at the mutual fund that it has created and promoted and financed as its product. It tends to look at the investors, his market, as customers. And he is told by we lawyers that there's a regulatory pattern and a state law pattern that says, no, it's not his product. It's a separate entity. Whether it's organized as a corporation, a trust, or even a separate account, just notations and a set of books, it's separate from your business, Mr. investment adviser. These customers, they're not simply customers. They're shareholders. And shareholders of a corporation, if you are the management, your duty – and I disagree with Ron's characterization – is not simply contractual, it goes beyond contractual. The duty, in many respects, can't be contracted away, and it can't be disclosed away. It's a fiduciary duty and it's a duty to consider the interests of the funds, and not simply to consider what you, Mr. adviser, believes is in your best business interest. That's difficult for an aggressive, intelligent, ethical businessman to grasp. And the function of the independent director is to make sure that whenever the adviser is doing something that affects the fund, there's a justification for it in terms, if not in terms of benefit to shareholders, at least the absence of harm to shareholders. If we look at funds and fund boards with that test in mind, I think we can find that there are a lot of good boards out there, not every board, for two reasons. Number one, unfortunately, boards are composed of human beings, and human beings, even in groups, are not perfect, and there are some weak boards.
Secondly, the culture in that or the discipline imposed by independent directors takes some years to develop, and it is strongest in the funds, not necessarily the larger funds or fund complexes, but the fund complexes that have operated under the '40 Act regulatory pattern for a number of years. It's weakest in the newer funds that are promoted and founded, promoted by an entrepreneur who is fighting for survival and some modicum of growth, as well as in the new entrants to the industry, from the banking and the insurance and industries that do not operate in the context where the customers are shareholders and that what they're selling is an entity and not simply their product or service. It takes a while for that culture to be changed and to accommodate the regulatory pattern. There is, however, a fair amount of criticism of the directors in connection with established complexes, and that criticism, to some extent, reflects, I think, a disconnect between what the directors think their job is and what is most important, what they give priorities, and what the regulators and some of the critics classify as priorities. The director considers himself the representative of the shareholder, and not the representative of the SEC. It's a shareholder body that has bought into the fund, bought into the management provided by the adviser on the basis of very good disclosure, and bought into a fee structure that's fully disclosed. It doesn't mean that the fee structure and the management can't be changed, but the fact of the matter is that's not what the shareholder looks to the board for. They don't look to the board to get lower fees after they became a shareholder, They look for the board to take responsibility for performance. While there's a lot of identity of interest between the manager and the shareholders in terms of investment performance, there are conflicts. What about the hot fund that's growing at a rapid pace? Is it in the interest of the adviser, and can the adviser bring himself to close down that fund at a point where it's gotten too big, or if not too big, the money is coming in too fast in order to invest it intelligently?
It's the job of the independent directors to raise questions and to ask the investment adviser to demonstrate why the investment adviser believes the fund can handle the company that's coming in at the rate it's coming in, and handle a fund at the size, the same thing that this fund is. The same questions have to be asked and are asked by independent directors when the investment adviser wants to use an existing portfolio manager to manage a new fund. Can the portfolio manager handle it? Will the portfolio manager's dilution of responsibility impair his performance? Those are the questions that directors should and do ask, and they consider that their paramount duty in making sure that the investment record that the shareholders bought into is one that will be maintained over the years as the funds change and grow, as portfolio managers come and go, and skills change with the direction of the markets. That they conceive to be their primary duty. A second major interest of shareholders is servicing. When they answer that phone – when they ring the fund, they want that phone to be answered within three, four, five rings. They don't want to receive busy signals. When they reach somebody, they want someone who is knowledgeable and who has the computer system that will allow them quickly to retrieve the relevant information and answer the questions and execute the transaction.
Ladies and gentlemen, in this day and age, telephone systems, computer systems that enable investment advisers to offer meaningful, effective shareholder services run into many millions of dollars. It's a highly complex business in and of itself. And that, in the view of most directors, is a very important aspect of their responsibility, to make sure that as the fund and the fund complex grows, this investment adviser is putting money back into the business so that he can offer the shareholders the quality of services that they got when they were induced to come into the fund, and to offer the shareholders additional services that are now appearing on fund information statements and the like, very important. Shareholders, or rather directors, do not consider themselves as having a primary function of being the chief negotiator to ratchet down fees. Yes, they have a responsibility to negotiate a contract that's fair and reasonable, but their primary responsibility is to make sure that the services that are being provided both shareholder and administrative and investment services are of the highest quality, and to make sure that as the investment adviser's business changes, and his relationships to the funds being managed change, that change operates to the benefit of shareholders. To the extent that a board does that, they've done a very good job, and I think by and large, in this industry, particularly with the more established funds and fund boards, that job is indeed being done very well, and that it's a job that has to be repeated at each and every meeting of the board, and it has to be renewed in an effort, at each and every new fund, and each and every new board, and new manager. But if a job is done in inculcating the investment manager that he's not dealing with a product, but with a separate entity, he's not dealing with a customer, but with a shareholder, and that the interests of his business might be different from those of the shareholders, at that point, the independent directors have done a very good job.
Mr. Goldschmid: Thank you, Dick. This has been an excellent session. I'm wise enough to know the Commission ought to have the right to ask the last questions. Does anyone have one that you want to ask?
Commissioner Unger: Well, Leslie's presentation pretty much begs the question of what the Commission should be doing.
Mr. Goldschmid: Leslie wanted a chance to answer that.
(Laughter.)
Mr. Phillips: I happen to have a laundry list here. We'll deliver it later. But basically, what I'm trying to say is we've got to be able to get to the new entrants to the industry. We have to get to all of the independent directors the relevant information. There are a number of ways that that could be carried out. And clearly if you look at the fees we pay for our filings, maybe we could consider a fraction of that as a tax for at least the introductory package of information to new directors. I don't want to cut out any of the service providers, the ICI offers some great resources, materials. There's a whole lot of information out there. We have to find a way to get the people to ask the questions in order to get the resources to them.
Commissioner Unger: I think this conference has gone a long way to doing that, and I applaud the Chairman with his leadership in this area. But I actually was at a board meeting of one of the exchanges recently, and they asked me at the conclusion whether the Commission had something like that in terms of educational materials for independent directors, since this has been a focal point of the Commission.
Commissioner Johnson: Listening to part of the session on conflicts of interest, it strikes me that we could all probably isolate on certain situations which constituted conflict of interest, but in the final analysis, we can't. We're not able to establish a litany of conflict of interest situations beyond any one human being, I think. And so we have to do the best we can, in good faith, and as people of integrity. And what we can do, I think one of the people in this room could walk into a situation and watch it for a little while, and know where the conflicts of interest were, know where the tension is, know where people aren't acting independently – just watch it, see it, and feel it.
Mr. Goldschmid: I think that picks up, too, on the idea of having independent counsel to help spot them and develop them each time. You've been a terrific audience. I'm going to steal –
Commissioner Carey: Harvey?
Mr. Goldschmid: I almost was going to steal. Go ahead.
Commissioner Carey: I just wanted to ask Dick Phillips if he believes a set of best practices should be established by the industry, and if not, why not, and if so, whether the SEC should play a role?
Mr. Phillips: Yeah. I think it would be helpful for the industry to establish best practices. The Commission can play a role by encouraging that. I don't know that it's a matter of statutory authority. I also think that the Commission can play a role by focusing on those funds that are not following best practices, and asking, in the course, through the inspection process, whether in fact the fund is being run as it should be in the interests of shareholders. And the issue is not technical compliance, okay. That's not the function of directors. The issue is, gee, are the directors' interests being considered at each and every turn in the operation of the fund?
Commissioner Carey: Thank you.
Mr. Goldschmid: I'm not sure if this is a conflict of interest or not, but I'm going to steal five minutes of your time at the break. We'll reconvene at 25 to the hour. Thank you all very much.
Wednesday, September 19, 2007
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