(Article from Registered Funds Alert, January 2019)
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Boards of registered funds serve a critical “watchdog” function for shareholders, but the growth of responsibilities given to directors, driven largely by SEC rulemaking, has made it increasingly difficult for board members to focus on their core function. After a keynote address by Dalia Blass, Director of the SEC’s Division of Investment Management, at the 2018 Investment Company Institute Mutual Funds and Investment Management Conference, participants in the mutual fund industry were eager to see whether her goal of “understanding where [the fund] board oversight role is most valuable” would translate into meaningful adjustments to the burdens placed on fund boards. On October 12, 2018, boards received some initial relief when the staff of the SEC’s Division of Investment Management issued a no-action letter to the Independent Directors Council confirming that the Division would not recommend an enforcement action if a board relies on reports from a fund’s Chief Compliance Officer that certain transactions were effected in compliance with the board’s procedures for such transactions, in lieu of the board being required to review such transactions and make the compliance determination itself (the “IDC No-Action Letter”).
The IDC No-Action Letter was a welcome first step to improve board efficiency, but there remain opportunities for the Staff to modernize further board responsibilities while still protecting shareholder interests. In this Alert, we provide background on the SEC’s Board Outreach Initiative, which ultimately led to the IDC No-Action Letter. We then discuss an additional area ripe for board oversight reform: co-investment programs.
The SEC’s Board Outreach Initiative and the IDC No-Action Letter
The effort to modernize board duties is not a new endeavor at the SEC. During her address, Ms. Blass referred to the “Board Outreach Initiative,” a program that has existed for over ten years. At his keynote address at the 2007 Investment Company Directors Conference, the then-Director of the SEC’s Division of Investment Management, introduced the initiative as a way for the SEC to help boards perform their duties and continue to add value for shareholders. As part of the initiative, the SEC solicited direct input from boards, including by meeting with boards at their regularly-scheduled meetings. Despite the apparent support for the initiative, the financial crisis and related Dodd-Frank Act and Financial Stability Oversight Council-driven rule-making initiatives that followed the crisis took the focus and momentum away from the Board Outreach Initiative.
In October 2017, the IDC wrote a letter to Ms. Blass requesting that the Division renew focus on modernizing board responsibilities. In that letter, the IDC noted that the earlier initiative had not resulted in meaningful recommendations from the SEC, and that the regulatory landscape had continued to change and additional responsibilities placed on boards over the past decade. The IDC urged the Division to take a fresh, comprehensive look at board duties in light of the current state of the industry. The IDC provided a number of preliminary recommendations, including changes to the three rules that were subsequently addressed in the IDC No-Action Letter. At her 2018 keynote address, Ms. Blass indicated the Staff had met with boards and groups of independent directors in an attempt to restart the initiative and intended to prioritize these efforts going forward.
The IDC No-Action Letter is the initial result of these efforts. In the letter, the Staff confirmed it would not recommend an enforcement action if, in lieu of a board making the required determinations that any transactions with affiliates covered under Rules 10f-3(c), 17a-7(e)(3) and 17e-1(b)(3) of the Investment Company Act of 1940 were compliance with board-approved policies and procedures adopted pursuant to such rules, a board were to instead rely on a report from the CCO to that effect. The SEC recognized the adoption of Rule 38a-1 under the 1940 Act reflected the SEC’s view that boards should oversee compliance matters instead of being involved in the day-to-day administration of a fund’s compliance program. The Staff reiterated that the board’s oversight role with respect to a fund’s overall compliance program remains unchanged by the IDC No-Action Letter.
The IDC No-Action Letter signals a notable shift in the Division’s view on a board’s ability to delegate additional responsibilities to a CCO to reduce the burden on the board. The SEC previously issued a letter to the IDC and Mutual Fund Directors Forum in which it clarified that a board may rely on a CCO’s report regarding the transactions covered by the rules addressed in the IDC No-Action Letter, but the board was still required to make compliance determinations under the rules. Under the IDC No-Action Letter, a board is no longer required to make such determinations.
Co-Investment Programs
We believe a logical next step in light of the IDC No-Action Letter and the SEC’s reinvigorated effort to improve board efficiency is for the Staff to take a fresh look at boards’ roles with respect to co-investment programs. The purpose of the conditions in co-investment exemptive relief applications is to mitigate conflicts of interest. In the way that the approval of Apollo Investment Corporation’s co-investment application signaled an attempt by the Staff to provide more practical exemptive relief and to take into account the realities of the asset management industry, we believe the next wave of exemptive relief applications should go a step further and provide an alternative to the current condition that boards must make certain findings regarding a potential co-investment transaction.
In our last Alert, we described the evolution of co-investment exemptive orders that have been granted by the SEC. In that Alert, we noted that renewed innovation in co-investment programs began with the order granted to Apollo in 2016. Although Apollo’s relief was a successful (albeit lengthy) negotiation between the Staff and Apollo, the relief issued to Apollo and subsequent applicants still requires that the board approve, at minimum, a registered fund’s participation in the initial co-investment transaction in a given issuer based on written information provided by the adviser. In approving a funds participation in a co-investment transaction, the board is presumably not asked to evaluate an investment on the merits, but instead must determine that:
- (i) the terms of the transaction are reasonable and fair to the fund and its shareholders and do not involve overreaching;
- (ii) the co-investment transaction is consistent with the interests of shareholders and the participating fund’s current objectives and strategies;
- (iii) the investment by other funds would not disadvantage the participating fund and the participating fund’s participation would not be on a different basis or less advantageous than that of any other fund(s); and
- (iv) the proposed investment will not involve compensation, renumeration or direct or indirect financial benefit to the adviser, any other fund, the affiliated funds or any of their affiliated persons. The board is also required to approve a fund’s participation in certain follow-on investments and disposition opportunities.
The IDC No-Action Letter raises considerations that also are present in co-investment programs. The IDC No-Action Letter did not seek to change a board’s responsibility to adopt procedures under the rules; instead, the relief allows a board to focus on its oversight role by not requiring it to determine affirmatively that each transaction was effected in compliance with board-established procedures. Similar to the rules that require a board, including the majority of independent directors, to adopt procedures that are reasonably designed to provide that transactions comply with the affiliated transaction requirements under the rules, a co-investment exemptive order require the board to oversee the procedures that ensure compliance with the terms and conditions of the exemptive order. However, the exemptive orders also require the board to make the determinations noted above for every single co-investment in which a registered fund proposes to participate in advance of the investment.
We believe the board’s role with respect to co-investment transactions should be focused on overseeing the review, approval and allocation process for these transactions. The board should not be required to make the transaction-specific determinations required by current exemptive orders. These determinations are more appropriately within the purview of the adviser’s investment and compliance personnel and it is not clear that any meaningful additional protections are gained by the board signing off on individual transactions. In practice, these potential co-investment transactions often come up between board meetings and on expedited timelines, causing logistical issues for both the board and the participating funds.
We believe that board reporting from the adviser on a quarterly basis should replace real-time board involvement. This approach aligns with the manner in which the board oversees how an adviser handles potential co-investment transactions in which a registered fund declines to participate. In addition, co-investment programs already require that the CCO oversee compliance of the program and prepare an annual report to the board regarding each fund’s compliance with the terms and conditions of the exemptive relief order. Similar to the IDC No-Action Letter, the board should be able to rely on certifications from both the adviser and the CCO stating that each co-investment transaction met the four mandatory conditions before a registered fund participated in the transaction. This change would allow the board to enhance its oversight function, as the board would receive the same level of information it does currently, just in the context of a quarterly board meeting during which any issues could be addressed face-to-face with the adviser. Fund shareholders will be sufficiently protected by the CCO’s and adviser’s fiduciary responsibilities and expertise, guided by the policies and procedures approved by the board and the board’s general oversight. We believe this change is aligned with spirit of Rule 38a-1.
The IDC No-Action Letter and the revival of the Board Outreach Initiative were welcome developments in the effort among industry participants to streamline fund board responsibilities. We believe the next area of focus for the Staff should be co-investment programs. Co-investment program changes could come through the exemptive relief process or through the no-action process with the Staff taking a position that it would not recommend enforcement if a fund board were to rely on certifications from the adviser and the CCO in lieu of making the four determinations in an exemptive order. Simpson Thacher will be actively monitoring this area and will address any developments in future Alerts.