Adoption of 1940 Act Rule Amendments – Mutual Fund
Governance and the Role of
Mutual Fund Independent Directors
On January 3, 2001 the Securities and Exchange Commission (the “Commission”) announced
the adoption of new rules and rule amendments relating to mutual fund governance and the role
of independent directors.1 The Commission also adopted new rules and rule and form
amendments to require mutual funds to provide investors with greater information about the
fund’s directors. The rules and amendments seek to affirm the important role that independent
directors play in protecting fund investors, reinforce their independence, strengthen their hand in
dealing with fund management, and provide investors with greater information to assess the
directors’ independence.
The new rules and amendments to rules and forms generally become effective on February 15,
2001, with the effectiveness of the rescission of rule 2a19-1 on May 12, 2001. After July 1,
2002, (1) persons may rely on certain exemptive rules (see footnote 3) only if they comply with
each of the three new conditions for use of these rules; (2) persons may rely on rule 17d-1(d)(7)
only if any joint insurance policy then in effect does not exclude coverage of litigation between
the independent directors and another insured person under the amended rule, and (3) funds must
begin to comply with the recordkeeping requirements of amended rule 31a-2.
The following summarizes the major changes in the rules and form amendments approved by the
Commission, highlighting the differences between these changes and those proposed in October
of 1999.2
I
Amendments to Exemptive Rules to Enhance Director Independence and
Effectiveness
The Commission adopted the proposed amendments to ten rules that exempt mutual funds and
their affiliates from certain prohibitions of the Investment Company Act of 1940 (the
“Exemptive Rules”)3 so long as certain conditions are met. For mutual funds that rely on the
Exemptive Rules:
1
Inv. Co. Act Rel. No. 24816 (the “Release”).
Inv. Co. Act Rel. No. 24082.
3
Rule 10f-3 (permitting funds to purchase securities in a primary offering when an affiliated broker-dealer is
a member of the underwriting syndicate); Rule 12b-1 (permitting use of fund assets to pay distribution expenses);
Rule 15a-4 (permitting fund boards to approve interim advisory contracts without shareholder approval); Rule 17a-7
(permitting securities transactions between a fund and another client of the fund’s adviser); Rule 17a-8 (permitting
mergers between certain affiliated funds); Rule 17d-1(d)(7) (permitting funds and their affiliates to purchase joint
liability insurance policies); Rule 17e-1 (specifying conditions under which funds may pay commissions to affiliated
brokers in connection with the sale of securities on an exchange); Rule 17g-1(j) (permitting funds to maintain joint
2
independent directors must constitute a majority of the board
independent directors must select and nominate other independent directors
any legal counsel for the independent directors must be an independent legal counsel
Board Composition Requirements
The fund must have a majority (more than half of the members) of independent directors. The
Commission considered but did not require a super-majority (two-thirds) of independent
directors.
Suspension of Board Composition Requirements
The Commission extended the current statutory time periods for compliance by a mutual fund
board with the board composition requirements. New rule 10e-1 suspends the board composition
requirements for 90 days (currently 30 days) if the board can fill a director vacancy or 150 days
(currently 60 days) if a shareholder vote is required to fill a vacancy.
Independent Legal Counsel
The Commission has clarified what constitutes an independent legal counsel. Under the rule
amendments, the independent directors are required to determine whether counsel is an
independent legal counsel. The Commission states that the scope of the rule is to be construed by
the discussion in the final release and not the proposing release.
Under the final rule amendments, the independent directors must reconsider at least annually the
independence of any independent legal counsel and must record the basis for their determination
in the board’s meeting minutes. To be considered an independent legal counsel, the independent
directors must:
determine that any representation of the fund’s investment adviser, principal underwriter,
administrator (collectively management organizations), or their control persons during
the past two fiscal years is or was sufficiently limited that the representation is unlikely to
adversely affect the professional judgment of the counsel in providing legal
representation, and
obtain an undertaking from such counsel to provide the directors with information
necessary for their determination, and to update promptly that information if the counsel
begins, or materially increases, the representation of a management organization or
control person.
insured bonds); Rule 18f-3 (permitting funds to issue multiple classes of voting stock); and Rule 23c-3 (permitting
the operation of interval funds by enabling closed-end funds to repurchase their shares from investors).
At the time independent counsel begins representation of a management organization or control
person, the independent directors must determine whether this new representation -- together
with any other representations of management organizations and control persons -- would
adversely affect the counsel’s professional judgment. To prevent the loss of the exemptions in
circumstances of dual representation, the rule provides for the independent directors to have
three months to make a new determination about the counsel or to hire a new independent legal
counsel.
II
Qualification as an Independent Director
Ownership of Index Fund Securities
New rule 2a19-3 conditionally exempts an individual from being disqualified as an independent
director solely because he or she owns shares of an index fund that invests in securities of the
investment adviser or underwriter of the fund, or their controlling persons. This exemption
requires that a fund be based on one or more broad-based indices. The rule does not include any
limit on the amount of such securities held by the director as was originally proposed.
Affiliation with a Broker-Dealer
The Commission has rescinded rule 2a19-1, which had provided relief from the section of the
1940 Act that defines when a fund director is considered to be independent. Release 24082 had
proposed an amendment to that rule to permit a slightly greater percentage of fund independent
directors to be affiliated with registered broker-dealers, under certain circumstances. The
passage in 1999 of the Gramm-Leach-Bliley Act, however, amended section 2(a)(19) of the 1940
Act and established new standards for determining independence under the circumstances
addressed in the proposal.
III
Form Amendments -- Disclosure of Information about Fund Directors
Ownership of Equity Securities in Fund Complex
The Commission adopted with modifications the requirement to disclose each director’s equity
ownership of fund securities in a fund complex.
Disclosure of Amounts Owned by Directors
The Commission amended form requirements to require that funds disclose a director’s holdings
of securities using dollar ranges rather than exact dollar amounts as originally proposed. Funds
will be required to disclose directors’ equity ownership using the following ranges: None; $1$10,000; $10,001-$50,000; $50,001-$100,000; or over $100,000.
Beneficial Ownership
The Commission adopted requirements to disclose the directors’ beneficial ownership in
accordance with the definition contained in rule 16a-1(a)(2) under the Exchange Act.
Disclosure of Director Ownership in Funds Overseen within the Same Family of
Investment Companies
The Commission adopted requirements to disclose: (1) each director’s ownership in each fund
overseen; and (2) each director’s aggregate ownership in any funds overseen within a fund
family. For purposes of determining a director’s holdings in a fund complex, the Commission
adopted a narrower definition of family of investment companies based on form requirements of
Schedule 14A, Form N-1A, Form N-2, and Form N-3.
Date of Disclosure
The Fund must include equity ownership information in the statement of additional information
and any proxy statement relating to the election of directors, subject to the requirements of those
forms.
IV
Conflicts of Interest -- Modifications to Persons Covered
Interested Directors
The Commission excluded interested directors from the conflicts of interest disclosure
requirements in both the statement of additional information and proxy statements. Funds will
be required, however, to describe the relationships, events, or transactions that make a director an
interested person.
Immediate Family Members
The Commission narrowed the scope of the definition of “immediate family members” covered
by the disclosure requirements to include only a director’s spouse, children residing in the
director’s household, and dependents of the director. The narrower definition ensures that
disclosure will only be required with respect to family members from whom directors can
reasonably be expected to obtain the required information.
Other Modifications
Threshold for Disclosure of Interests, Transactions, and Relationships
The Commission adopted a specific $60,000 threshold for disclosure of interests, transactions,
and relationships as contained in the existing proxy rules, thus eliminating the need to make
subjective materiality determinations.
The Commission cautioned that this change does not, however, reflect a determination that the
$60,000 threshold may be equated with materiality. The antifraud provisions of the federal
securities laws may obligate funds to disclose a material conflict of interest between a director
and the fund or its shareholders without regard to the $60,000 threshold. A transaction between
a director and a fund’s adviser may constitute a material conflict of interest with the fund or its
shareholders that is required to be disclosed, regardless of the amount involved, if the terms and
conditions of the transaction are not comparable to those that would have been negotiated at
arms-length in similar circumstances.
Time Periods
The Commission adopted, as proposed, a five-year time period for disclosure of positions and
interests of directors and immediate family members in a proxy statement for the election of
directors. It reduced, however, the time period for disclosure of positions and interests in the
statement of additional information to two calendar years.
The Commission also adopted, as proposed, the requirement to disclose material transactions and
relationships since the beginning of the last two completed fiscal years in the proxy statement for
the election of directors. In the statement of additional information, however, it modified the
proposal to require disclosure of transactions and relationships during the two most recently
completed calendar years, rather than the last two fiscal years, as proposed.
Routine, Retail Transactions and Relationships
As adopted, the conflicts of interest disclosure provisions clarify that the exception for routine,
retail transactions and relationships, such as a credit card or bank or brokerage account
transactions also extends to residential mortgages and insurance policies, unless a director is
accorded special treatment. The Commission also noted that the exception for routine, retail
transactions and relationships is not limited to the enumerated transactions and relationships but
also extends to other routine, retail transactions and relationships so long as the director is not
accorded special treatment.
The Release has provided the industry with an enormous volume of regulatory changes and
interpretations to evaluate, assess, and respond to in the coming months. We look forward to
working with you on the most recent development for directors, for funds and their service
providers.
Stephen E. Roth 202.383.0158
Frederick R. Bellamy 202.383.0216
Steven B. Boehm 202.383.0176
Kimberly J. Smith 202.383.0314
David S. Goldstein 202.383.0606
Catherine S. Wooledge 202.383.0446
*The Release is found at http://www.sec.gov/rules/final/34-43786.htm