"How independent should an independent director of an investment company be?"

"Do we need to have more independent directors on the board of an investment company?"

"Should independent directors hire separate legal counsel to represent them?"

The Securities and Exchange Commission is now asking these questions. In October the SEC proposed a series of amendments to the board composition rules under the Investment Company Act of 1940, as amended. Now awaited is adoption of final rules that will strengthen the independence of fund directors and enhance the effectiveness of board governance.

Investment companies often are a major component of the financial services packages that banks provide their clients. Banks may offer proprietary funds (brandishing the bank's name), private label funds (bank-sponsored but managed by outside parties), or unrelated third-party funds. In any case, these funds are regulated by the Investment Company Act.

Congress emphasized in the law that an investment company's board should protect the assets of the investors, acting as independent watchdogs to ensure that applicable laws are obeyed, investment guidelines are followed, and the business is operated properly.

This oversight function is necessary because an investment company does not have any employees; instead, the fund officers handling the daily operations are, typically, paid employees of the investment adviser (which, in a bank holding company arrangement, is often a wholly owned subsidiary).

In sum, the board of a fund is expected to provide the policies for, and a periodic check on, management's daily operations.

Under the Investment Company Act, board members are classified as either independent (also called outside, noninterested, or unaffiliated) or interested.

Persons who are deemed to be interested include those "affiliated" with the fund (such as a 5% shareholder, officer, director, partner, or employee); members of such their immediate families; any interested person of any investment adviser of or principal underwriter for the fund; any recent legal counsel for the fund; and any registered broker or dealer (or affiliated persons).

The Investment Company Act requires that at least 40% of a fund's board be independent directors.

To strengthen fund governance, the SEC proposes to amend the act so that:

  • Independent directors constitute at least a majority of each board of directors.
  • Independent directors select and nominate other independent directors.
  • Any legal counsel for the independent directors be an "independent" legal counsel.

The rationale behind these proposals is that a board with a majority of independent directors, who would control the voting process, is better equipped to perform its duties of monitoring potential conflicts of interest and protecting the fund and its shareholders from outside influences.Furthermore, the SEC reasons, independent directors understand their duty of loyalty to the shareholders rather than management. To avoid conflicts, legal counsel for the independent directors may not simultaneously represent the investment adviser, the underwriter, or the administrator for the fund.
The SEC proposes additional amendments that would:

  • Prevent otherwise capable individuals from being unnecessarily disqualified from serving as independent directors.
    This proposal would permit directors to be considered "independent" even if they are affiliated with a broker-dealer (other than one itself affiliated with the fund) or own shares of an index fund that holds limited interests in the fund's investment adviser or principal underwriter.
  • Protect independent directors from the costs of legal disputes with fund management, by requiring the purchase of joint insurance policies by funds and their affiliates to include coverage for expenses incurred by the independent directors in any such litigation.
    This would encourage the purchase of insurance that would enable independent directors to focus on their task of overseeing the fund, rather than worrying about having to use their personal resources to defend themselves in legal disputes with the investment adviser.
  • Require funds to keep records of their assessments of a director's qualification as independent. This proposal would require the investment adviser to document how it determined that a person was qualified to be considered an independent director.
  • Temporarily suspend the 40% minimum requirement for independent directors if a fund falls below the threshold as a result of an independent director's death or resignation.
  • Exempt funds from the requirement that the shareholders ratify or reject the directors' selection of an independent public accountant if the fund establishes an audit committee composed entirely of independent directors, who would approve the fund's accountants.

Finally, the SEC wants to improve the disclosure that funds provide about their directors. Accordingly, the SEC proposes to require funds to inform shareholders fully about:

  • The identity and business experience of its directors.
  • The amount of fund shares owned by the directors.
  • Potential conflicts of interest involving the directors.
  • The board's role in governing the fund's operations.

This information would be required to appear in the fund's annual report to shareholders, its statement of additional information, and its proxy statement to elect directors. The information optionally may appear in the fund's prospectus.The aim of the disclosure changes is to give shareholders detailed information about the directors' affiliations and to highlight possible issues concerning their prior business or familial relationships.
Mr. Eppner is a partner in the New York office of the Cadwalader, Wickersham & Taft law firm. Mr. Kanefsky is special counsel in the firm's corporate department.

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