(Article from Registered Funds Alert, May 2016)
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Independent directors of registered funds are often referred to as “watchdogs” or, more recently, “gatekeepers,” who guard the interests of shareholders against the concerns of conflicts of interest, self-dealing and other abuses that gave rise to the 1940 Act. The general consensus among both the industry and the SEC is that the role of independent directors is one of oversight. Reasonable minds disagree, however, on the meaning of “oversight,” and the expectations that the SEC has for independent directors have evolved over time. As the SEC has grown to expect more and more of independent directors, it raises the question of whether there is a point where independent directors become too involved in day-to-day management, potentially decreasing the value of their oversight and jeopardizing their independent perspective.
The Role of the Board According to the 1940 Act’s Legislative History
To establish a baseline of expectations for independent directors, it is helpful to look to the legislative history of the 1940 Act. There was significant discussion regarding the statute’s requirement that independent directors make up a significant portion of a fund’s board. The original draft of the statute would have required a majority of the board to be independent. The industry was very active in the process of revising the initial draft, and numerous industry representatives appeared before Congress to share their views and offer recommended changes. Many of these industry representatives were asked about their views regarding the statute’s proposed requirement of having a majority of independent directors.
“ As the SEC has grown to expect more and more of independent directors, it raises the question of whether there is a point where independent directors become too involved in day-to-day management, potentially decreasing the value of their oversight and jeopardizing their independent perspective.”
While some argued that there was no need for independent directors, many acknowledged the value that independent directors would bring to the table. While generally supporting a requirement for independent directors, industry representatives rallied against the statute’s proposed requirement that independent directors make up a majority of a fund’s board. F. Wilder Bellamy, president of National Bond & Share Corporation (a closed-end fund) stated his view that independent directors should not control the board because shareholders are entrusting management, not outsiders, with their investments. Given the intent behind requiring independent directors, Mr. Bellamy stated that he believed that he did not “see any representation [of shareholder interests] that could be supplied by a majority that could not be supplied by a minority for, after all . . . the cold light of day is the thing that keeps people from doing things that are wrong. As a rule the minority directors can see that the light of publicity is turned on transactions just as well as the majority can.”[1] This line of reasoning ultimately carried the day, as the statute was adopted with a requirement that independent directors comprise 40% of a fund’s board.
As for the role of fund directors, Arthur Bunker, an executive vice president of The Lehman Corporation (one of the largest closed-end funds at the time) described it as follows:
“ I think it is fair to say that, in general, the function of the directors is to keep the company in contact with the outside world and to be responsible for the determination of general policy. In the matter of the investment company, this would mean that they would be responsible for such major questions as to the general program of acquisition or disposition of securities and, in a general way, for the determination of fields of investment.
But this is a very different thing from asking them to pass upon every minute purchase and sale, to examine every report and recommendation made by the operating staff, and to consider every daily investment opportunity which may arise. I am sure you will agree that these distinctions between the operating staff and the directorship staff are fair distinctions.[2]”
Mr. Bellamy and others expressed similar understandings of the role of fund directors.
The SEC’s Current Expectations Regarding the Role of Independent Directors
Fast-forwarding more than 75 years to the present, it is clear that fund directors are more involved in examining reports and recommendations of management than was contemplated in 1940. While prominent SEC officials such as Chair Mary Jo White and David Grim, Director of the Division of Investment Management, acknowledge the distinction between management and oversight, the SEC’s rulemaking, examination and enforcement initiatives indicate that the SEC expects independent directors to get increasingly involved in overseeing day-to-day operations. The problem is that the line between oversight of day-to-day operations and actual management of such operations is thin and not always apparent. For example, commenters on the SEC’s recent liquidity management and derivatives rule proposals have expressed concern regarding provisions that would require directors to approve detailed policies and procedures and evaluate key thresholds that appear to require technical knowledge and encroach upon day-to-day operations and responsibilities of a fund’s adviser.
In a speech at the Mutual Fund Directors Forum 2016 Policy Conference, Chair White stated that certain recent events, including when a service provider was unable to calculate the net asset value of funds due to a computer glitch, “raise a number of new questions for fund directors related to their oversight of operational risks” and that directors should be “thinking about and asking fund managers whether these events could happen at your fund, how to prevent them from happening, and how to respond promptly and effectively if they do occur.”[3]
The notion that independent directors bear some responsibility for oversight of operations issues demonstrates how far the 1940 Act framework, in practice, has drifted from the board being involved in “major questions as to the general program of acquisition or disposition of securities and, in a general way, for the determination of fields of investment.” This is not to say that fund directors should shy away from asking fund management about these issues, but statements like Chair White’s assume that directors have a responsibility to oversee day-to-day operational risks. It is not clear that fund boards are designed to do so, even if the SEC believes that it is their job to do so.
Concerns Regarding Potential Enforcement Actions Against Independent Directors
The disconnect between the SEC’s expectations and the traditional role of the board opens the door for enforcement actions targeting independent directors. Chair White has put directors on notice, stating that “[w]hen directors fail to perform their duties, they should expect action to punish and deter such conduct.”[4]
“ The disconnect between the SEC’s expectations and the traditional role of the board opens the door for enforcement actions targeting independent directors.”
At the same time, she expressed an expectation that independent directors need to develop (or hire) expertise in areas such as cybersecurity, derivatives, liquidity, trading, pricing and fund distribution. By expanding the scope of directors’ responsibility to include day-to-day operations such as cybersecurity, trading and pricing, directors could be subject to additional enforcement risk. Anthony Kelly, co-chief of the Asset Management Unit of the SEC’s Division of Enforcement, has stated that the SEC “anticipate[s] focusing on gatekeepers, and where appropriate, we will bring actions.”[5]
In addition to the expanded scope of director responsibilities, fear of SEC enforcement targeting independent directors is further heightened by actions that indicate an apparent willingness on the part of the SEC to substitute its judgment for that of the board. A recent enforcement case cited by Chair White as a basic failure on the part of independent directors arguably illustrates that the SEC is willing to bring an action if it disagrees with the judgment of the independent directors. As discussed in a prior Alert, in the Commonwealth case, the SEC alleged that the independent directors failed to fulfill their duty under Section 15 of the 1940 Act to request and evaluate such information as “may reasonably be necessary to evaluate the terms of any contract whereby a person undertakes regularly to serve or act as investment adviser.” While the SEC acknowledged that the independent directors requested appropriate information from the funds’ adviser, the alleged violation was that they did not follow-up with the adviser for information that was missing from the adviser’s responses and therefore did not evaluate all information necessary to make a determination of whether to renew the advisory contracts. While as a general practice a fund board should seek responses to all information requested, it is notable in this case that the adviser was paid no advisory fees for the periods in question and much of the information alleged not to have been provided related to fee comparisons, profitability and economies of scale. It would not be unreasonable for independent directors to conclude that evaluating such information was not necessary to renew an advisory contract pursuant to which the adviser had not been paid any advisory fees.
Even more troubling are the mixed messages the SEC is sending regarding the expectation that independent directors are responsible for obtaining certain types of information from service providers even if they have no legal mechanism to compel them to provide it. In a January 2016 guidance update, summarized in our last Alert, the staff of the SEC’s Division of Investment Management noted that independent directors have a Section 15(c)-like duty under Rule 12b-1 to request and evaluate all information reasonably necessary to consider approval or renewal of a Rule 12b-1 plan. In this respect, the staff stated its belief that independent directors should receive information from financial intermediaries with respect to distribution and servicing arrangements. Many industry observers have commented that boards have no mechanism to require financial intermediaries to provide such information, as they currently have no legal duty to do so. While some SEC officials, such as Division of Investment Management branch chief Thoreau Bartmann, have noted that the SEC recognizes that “there is a power imbalance” and that “intermediaries don’t want to provide this information,” other SEC officials have expressed a different view.[6]While speaking on a panel at the Practising Law Institute’s 2016 Investment Management Institute in New York, Ken Joseph, Associate Regional Director of the Investment Adviser/Investment Company Examination Program in the SEC’s New York regional office, stated that boards have an obligation to have adequate information no matter what. He expressed the view that “‘I can’t get the information’ is not a valid excuse. . . there is no carveout in the federal securities law for ‘I can’t find the information’ or ‘they won’t give it to me.’”[7] When considered in relation to the Commonwealth action, this statement demonstrates how the SEC’s changing expectations may be putting directors between a rock and a hard place.
[1] See Investment Trusts and Investment Companies: Hearings Before a Subcommittee of the Senate Committee on Banking and Currency, 76th Cong., 3rd Sess. 423 (1940) (statement of F. Wilder Bellamy, President, National Bond & Shareholder Corporation).
[2] Id. at 413 (statement of Arthur Bunker, Executive Vice President, The Lehman Corporation).
[3] See Mary Jo White, Chair, SEC, The Fund Director in 2016: Keynote Address at the Mutual Fund Directors Forum 2016 Policy Conference (Mar. 29, 2016).
[4] Id.
[5] See Greg Saitz, Intermediary Won’t Give Up Info? SEC Feels Your Pain, Ignites, May 3, 2016.
[6] See id.
[7] See Greg Saitz, No Excuses in Fight for Broker Information: SEC Official, Ignites, Mar. 22, 2016.