(Article from Registered Funds Alert, May 2017)
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Because mutual fund boards oversee an outsourced business model – i.e., because all actions taken on behalf of a fund are by agents, not employees – a mutual fund board is by design an oversight board. As such, day-to-day management of actions taken by those agents, such as the investment adviser, administrator or distributor, is not properly within their purview. Given this design, a classical view of the role of the fund board is one that focuses on oversight of conflicts of interests between the funds they oversee and those agents that have contractual relationships with the funds.
Historically, this conflict of interest view has been embodied in both the statutory design of the 1940 Act and the rulemaking thereunder. For example, directors are charged with reviewing advisory contracts on an annual basis under the 1940 Act, and for blessing affiliated cross-trades under a rule under the 1940 Act. Over time, however, the SEC has placed growing responsibilities on directors of registered funds. In some cases, these responsibilities relate to conflicts of interest oversight. In others, these responsibilities veer closer to day-to-day management. The responsibilities that boards feel they must shoulder sometimes stem from exemptive orders, informal Staff guidance, administrative actions or even speeches or remarks by SEC officials. Even if one were to grant arguendo that each responsibility placed on a fund board is appropriate, in the aggregate the sheer volume of these requirements impedes a fund board’s ability to focus on the key issues that it was intended to handle.
Industry groups, and the SEC, seem to recognize that it may be time to revisit some of the requirements imposed on fund directors.
Time for the SEC to Take Action
It has been 25 years since the Division of Investment Management (the “Division”) issued a formal report that included recommended reforms regarding the role of fund directors. In framing its recommendations, the report noted that “in order to allow directors to devote their time and attention to truly important matters, we believe that provisions that require directors to conduct reviews and [make detailed] findings that involve more ritual than substance should be eliminated.” Nine years ago it appeared as though the Division was on a path to produce a similar report based on the “Director Outreach Initiative” during which the Division’s then Director, Andrew J. Donohue, attended numerous meetings with fund boards and received many comments from various stakeholders on board responsibilities. Unfortunately, unlike the previous initiative in 1992, no formal report was issued as the financial crisis quickly diverted the Division’s attention to more immediate and urgent matters. During the ICI’s annual mutual funds conference in March 2017, Amy Lancellotta, Managing Director of the Independent Directors Council (“IDC”), indicated that the IDC intended to push the SEC to revisit and publish a report building off of the Division’s work during Mr. Donohue’s tenure.
It appears as though the Division may finally be moving toward taking some action to reduce the burden on directors. Shortly after Ms. Lancellotta’s remarks, during the Practicing Law Institute’s Investment Management Institute in March 2017, the Division’s current Director, David Grim, responded to a question regarding reassessing board responsibilities by stating:
“ … One of the … great developments in the asset management industry has been the compliance rule and what it has spawned in terms of enhanced compliance within the industry and in certain targeted ways I think … we’ve kind of tried to calibrate things where the board role recognizes the existence of the CCO and the compliance rule. But a lot of our rules predate the existence of the compliance rule around board obligations and so I think this is an important topic for IM and potentially for the Commission to spend some time thinking about and try to see if we can come up with ideas to enhance the way boards oversee funds.”
To the extent that the Division is actively considering reducing the burden on fund boards, it should begin with the still-relevant recommendations of the IDC and the Mutual Fund Directors Forum (the “MFDF”) made in 2008 in response to the earlier Director Outreach Initiative.
In a 2008 letter to the Division, the IDC raised points similar to Mr. Grim’s recent remarks. In particular it stated, “[i]n many instances, the matters are already being well handled by the fund CCO, and board-level review has become an unnecessary and duplicative layer on a well-functioning system.” As a result, the IDC made specific recommendations for Rules 10f-3, 17a-7, and 17e-1 under the 1940 Act that would (i) shift review of quarterly reports to a person designated by the board (such as an employee of the investment adviser), rather than to the board itself and (ii) allow a designee to approve changes to the policies and procedures under such rules and report material changes to the board. Similarly, the IDC suggested that a board did not need to receive reports under Rule 17f-5 (foreign custody), but rather such reports should be provided to a designee. The IDC also recommended that the requirement under Rule 22c-1 that a board set the time or times during the day that a fund’s net asset value is computed be reassigned to the fund’s investment adviser. Finally, the IDC also commented on what must be discussed in shareholder reports regarding the factors that form the basis for a board’s approval of an investment advisory contract. Specifically, it advised eliminating the discussion of whether a board relies upon comparisons of the services to be rendered and the amounts to be paid under an investment advisory contract with those of other types of clients, such as pension funds or separately managed accounts. The IDC argued that these comparisons may not be relevant to a board’s consideration of a fund’s investment advisory agreement but still require time and resources to address during the Section 15(c) process.
In addition to the IDC’s efforts, the MFDF offered several recommendations in its own 2008 letter sent in response to the Director Outreach Initiative. It identified a number of responsibilities that were potentially too detail-oriented (to the point of possible distraction), such as (i) the quarterly review of amounts expended under Rule 12b-1 plans, (ii) the mechanics of making fair value determinations and (iii) review of routine transactions involving certain affiliates. The MFDF believed that these burdens could be reduced by either (i) eliminating or scaling back these requirements or (ii) providing boards with more freedom to delegate, which would allow boards to “manage their own operations and focus on those areas and activities they believe provide the most benefits to their shareholders.”
SEC Rulemaking Proposals Send Mixed Signals
While Mr. Grim’s remarks indicate a potential willingness on the part of the SEC to reduce the burdens on fund directors, the SEC’s 1940 Act rule proposals in 2015 and 2016 indicate otherwise. Rules and proposals regarding liquidity risk management and derivatives proposed to add specific duties to fund boards that either could fall appropriately under the framework of Rule 38a-1 (the compliance rule) or appeared to involve day-to-day management oversight. In commenting on the proposed derivatives rule, for example, the IDC and others took issue with several aspects of the proposed rule, including questioning the need for the board to approve specific policies and procedures or make determinations relating to portfolio management and investment risk management functions. The IDC argued that if a fund wanted to rely on the proposed rule, it would need to concurrently comply with Rule 38a-1 and adopt policies and procedures reasonably designed to prevent violations of the proposed rule and the board would be required to approve such policies and procedures and oversee compliance with them. As a result, mandating specific approvals under the proposed rule was neither necessary nor warranted. The MFDF echoed this sentiment in its 2016 comment letter and stated that by “imposing these duties directly, rather than making them subject to section 38(a) of the Act, the Commission appears to be suggesting that boards have a more direct role than just overseeing the fund’s compliance with applicable laws.”
As with proposed derivatives rule, the IDC and MFDF also took issue with certain aspects of the recently adopted “swing pricing” rule that they feared potentially placed additional management-like responsibilities on a fund board. Under Rule 22c-1, effective November 19, 2018, an open-end fund may, under certain circumstances, use “swing pricing” to adjust its current NAV per share for certain shareholders to mitigate dilution as a result of their purchase or redemption activity. However, for a fund to avail itself of this flexibility, its board must specifically sign off on a litany of items including (i) the swing pricing policies and procedures, (ii) the swing thresholds and upper limit on the swing factors used, (iii) designation to the fund’s investment adviser or an officer responsible for administering the swing policies and procedures and (iv) reviewing no less frequently than annually a written report prepared by the designee who administers the swing policies and procedures. Consistent with its 2008 letter, in its 2016 comment letter regarding the swing pricing rule, the IDC recommended that while the board can oversee swing pricing processes, the investment adviser, rather than the board, should designate the person responsible for administering the swing pricing policies and procedures so as to avoid being drawn into management-level decisions. Similarly, in its 2016 comment letter, the MFDF encouraged the SEC to “assign directors a role that is consistent with their using their business judgment to oversee funds on behalf of the fund’s investors and be careful not to give directors and boards operational-type responsibilities.” A review of the adopting release for the swing pricing rule indicates that the SEC was not convinced by these arguments, and the board’s responsibilities under the rule were largely adopted as proposed. With respect to the recently adopted liquidity risk management rule, however, similar arguments were at least partially accepted by the SEC, as the adopting release clarified that a board is responsible for general oversight, but not for changes to a liquidity risk management program or setting a fund’s highly liquid investment minimum.
If the Division considers streamlining board responsibilities, it should not only begin with the still relevant recommendations of the IDC and MFDF made in 2008, but also consider the aggregate burden on boards in pending and future rulemakings. We believe a guiding principle for board oversight is one that requires board intervention primarily where there is a possibility of a conflict of interest between the interests of a service provider to a fund and the fund itself. Furthermore, such conflicts should be evaluated in light of the likelihood that such conflicts will disadvantage the fund, and not merely on the premise that a conflict could exist in theory where it will not in practice. We also observe that industry participants often resolve thorny regulatory issues by proposing to the SEC that, instead of prescriptive rules with respect to certain practices, the SEC should simply leave an issue to a board to oversee. It will be in the ultimate long-term interest of all industry participants, including the regulator, if boards are freed up to focus on the issues of greatest importance to fund investors.