The Investment Lawyer Covering Legal and Regulatory Issues of Asset Management

VOL. 22, NO. 6 • JUNE 2015

Creating an Effective, Functioning and Legally Compliant Mutual Fund Board By Thomas A. Bausch, Ellen R. Drought, and Pamela M. Krill

utual fund directors are entrusted with board. New directors are usually nominated by the many key responsibilities under the nominating committee or independent directors as MInvestment Company Act of 1940, as a group. In addition to identifying candidates with amended (1940 Act), such as approval of the advisory appropriate qualifi cations and skills who are able to agreement and monitoring for potential confl icts on mesh well with the other directors, the nominat- behalf of fund shareholders. Under the 1940 Act and ing committee must also take into account the legal state law, directors are responsible for overseeing the requirements on board composition under the 1940 operations of the fund and its portfolios, including Act and state law, including shareholder approval the fund’s investment objective and policies, perfor- of directors and minimum percentages of indepen- mance, risk management, regulatory compliance, dent directors. Once a properly constituted board is and service provider arrangements, among numer- in place, the board must ensure that directors con- ous other duties. Independent directors play a par- tinue to contribute and serve eff ectively on behalf of ticularly important role in fulfi lling these duties. As shareholders. noted by the Supreme Court, independent directors Th is article will explore how directors are identi- serve as “independent watchdogs” who act as a check fi ed, nominated, elected and retained as part of an on the management of investment companies.1 Th e eff ective and legally compliant mutual fund board. mutual fund industry is thus heavily dependent on Because “interested” directors are normally readily the successful recruitment and retention of qualifi ed identifi able based on their relationship with the fund independent directors to serve on the board.2 Th ere sponsor or other service provider, we will focus on are currently approximately 1,900 independent the recruitment, retention and retirement practices directors overseeing more than $18 trillion in assets of independent directors. at approximately 10,500 investment companies.3 Ideally, a board should include directors with I. Selection and Nomination varying skillsets and backgrounds, as well as expe- of Independent Directors rience in areas relevant to mutual funds, such as Fund governance has taken the spotlight at fi nance, investments, distribution, and legal mat- various times in recent years, such as in 2004 when ters. Individual directors must be able to collabo- the Securities and Exchange Commission (SEC) rate and function together eff ectively as a working adopted a series of amended fund governance rules

“designed to enhance the independence and eff ec- from management, while at others, the independent tiveness of fund boards and to improve their ability directors will operate completely independently of to protect the interests of the funds and fund share- management to identify new independent director holders they serve.”4 Th e amendments provided candidates. In the 2001 Adopting Release, the SEC that funds relying on ten common exemptive rules addressed the role of the adviser and shareholders in (Exemptive Rules)5 comply with certain governance the process: requirements, including rules on board composition, an independent chairman of the board,6 an annual Several commenters asked that we clarify self-assessment, executive sessions and the authority the extent to which fund shareholders or a to retain independent director staff . fund’s adviser may participate in the selec- However, since 2001, incumbent independent tion and nomination process under the directors have been required to select and nominate amendments. Control of the selection and new independent directors if they served on the boards nomination process at all times should rest of funds relying on the Exemptive Rules pursuant to with a fund’s independent directors. Th ese amendments adopted at that time.7 Th e SEC’s rule amendments are not intended to supplant proposals that set forth the self-selection and self- or limit the ability of fund shareholders nomination requirement borrowed from the best under state law to nominate independent practice recommendations of an advisory group orga- directors. Th e adviser may suggest inde- nized by the Investment Company Institute (ICI),8 pendent director candidates if the inde- as well as a public roundtable hosted by the SEC to pendent directors invite such suggestions, discuss the role of independent directors of mutual and the adviser may provide administrative funds.9 In connection with the proposal, former SEC assistance in the selection and nomination Chairman Arthur Levitt said, “[i]ndependent direc- process. Independent directors, however, tors should nominate any new independent directors. should not view participation by sharehold- Many boards already meet that standard. Funds that ers and investment advisers in this process pay for their own distribution expenses under Rule as precluding or excusing the independent 12b-1 are required to have self-nominating indepen- directors from the responsibility to canvass, dent directors. If the primary role of independent recruit, interview, and solicit independent directors is to protect the shareholder interest and act director candidates.11 as a check on management, wouldn’t self-nominating independent directors be more eff ective—not just in Notwithstanding the ability of an adviser to sug- distribution issues—but in any confl ict of interest gest candidates, independent directors’ responsibility with management?”10 Even for funds that do not rely to select and propose candidates requires that they on the Exemptive Rules, many funds operate under a play an active role in the recruitment and consider- nominating committee charter or governance policy ation process. Th e SEC Staff has stated that indepen- that requires the independent directors to select and dent directors may not satisfy this requirement if the nominate other independent directors. only candidates considered were nominated by some- While independent director nominees of most one other than the independent directors and not all funds must be selected by the incumbent indepen- of the candidates ultimately nominated for election dent directors, either due to legal requirements, were interviewed by the independent directors.12 internal governance policies or best practices, what It is common for the nominating committee this means in reality will vary from fund complex to handle the independent director recruitment to fund complex. Some boards may welcome input process. Alternately, in the case of small boards,

Copyright © 2015 by CCH Incorporated. All Rights Reserved. VOL. 22, NO. 6 • JUNE 2015 3 the independent directors may not have formed a shareholders. Th e SEC had previously taken the nominating committee and may handle the recruit- position that Section 16 required a mutual fund’s ment process as a group. As a best practice, the public shareholders to elect the fund’s directors.14 nominating committee (or full board, depending Subsequently, the SEC’s view on Section 16 evolved on the structure) should meet at least annually to to permit election of directors by the initial share- review prospective candidates, the composition of holder of a mutual fund (typically, the investment the board, and desired skill sets and other criteria of adviser or other sponsor).15 Th ereafter, vacancies on new candidates.13 Th is also may be handled as part the board may be fi lled by election by the current of the annual self-assessment process. In the case of board of directors, provided that immediately after unexpected vacancies or to recruit board members fi lling such vacancy, at least two-thirds of the board with a specifi c skill set, the nominating committee has been elected by shareholders.16 may wish to retain a third-party search fi rm. If, at any time, less than a majority of direc- Once a candidate or candidates have been iden- tors has been elected by shareholders, Section 16(a) tifi ed, the incumbent independent directors typically requires a board to call a meeting of shareholders to meet with the prospective nominee to assess his or her elect directors within 60 days. Rule 10e-1 under the interest, ability and potential “chemistry” with the 1940 Act extends this period to 150 days if there rest of the board, and to address any questions, before has been a death, disqualifi cation, or bona fi de res- formally nominating the candidate. In addition, the ignation of any director which results in the fund candidate should complete an independent director not being able to meet the 1940 Act requirements questionnaire to identify any potential confl icts, affi li- regarding the composition of the board of direc- ations, disclosure items or other independence issues. tors. In the adopting release for Rule 10e-1, the SEC Once the incumbent directors agree on the selec- noted that it was allowing the extended time period tion of a candidate, he or she will be nominated for to provide relief if the fund no longer has a majority election by the full board and, if required, fund share- of independent directors because of the sudden loss holders. If a candidate is submitted for election by of one or more directors, without facing the conse- shareholders, the proxy statement must disclose the quences of losing the availability of the Exemptive nomination process a fund uses in selecting candidates Rules.17 A footnote to the release states: “Th e time for election. Th ese disclosure requirements, as well as periods begin to run when the fund no longer meets the requirement for shareholder approval of direc- the applicable board composition requirement, even tors, are discussed below. Additionally, in nominating if the fund is not yet aware that it no longer meets the candidates for service on the board, incumbent board requirement. Funds and directors should be mindful members should be aware of the 1940 Act require- of their responsibilities to maintain the required per- ments pertaining to the percentage of the board that centage of independent directors, and should moni- must be comprised of independent directors, which tor director independence (and other composition are also discussed below. Th e shareholder approval issues) accordingly.”18 Given the wording of Rule and director independence requirements may infl u- 10e-1 and the release’s reference to “other composi- ence a board’s consideration of certain candidates and tion issues,” the extended time periods should apply the timing of a candidate’s nomination. not only when a board does not have the requisite number of independent directors but also if it does II. Shareholder Approval not meet the shareholder election requirements. Requirements Section 16 does not prescribe the manner in Section 16(a) of the 1940 Act requires that which directors must be elected. Prior to calling a fund’s initial board of directors be elected by a shareholder meeting to elect directors, a board

Copyright © 2015 by CCH Incorporated. All Rights Reserved. 4 THE INVESTMENT LAWYER should understand applicable state laws and any but this provision of the rules was never imple- requirements set forth in the fund’s governing docu- mented due to a legal challenge.20 ments regarding shareholder meetings and the elec- In connection with the change of control of an tion of directors. adviser, Section 15(f) of the 1940 Act provides A board should consider the 1940 Act’s share- that at least 75 percent of the board must be holder election requirements when addressing the independent for at least three years if the fund’s succession issues discussed in Section VI below. A adviser or any of its affi liates received any benefi t thoughtful approach to succession planning with in connection with such change of control. the shareholder approval requirements in mind can serve to provide the board with maximum fl exibility Th e 1940 Act does not prescribe a minimum size and minimize the number of shareholder elections of a board, and the size of mutual fund boards varies. that will need to be held at (potentially) signifi cant Regardless of the size of the board, the composition cost to the fund. of its members should ensure there are enough directors, and enough independent directors, to “perform III. Independence the required oversight functions, as well as to con- According to a joint study conducted by the duct thorough deliberations and to render sound Independent Directors Council (IDC) and the decisions.”21 A survey from Management Practice Investment Company Institute (ICI), 85 percent of Inc., an industry consulting group, indicates that fund boards were composed of at least 75 percent the majority of fund boards have three to six inde- independent directors as of year-end 2012, as pendent members, with eight percent at one-two opposed to 46 percent of fund boards in 1996.19 independent members and 10 percent at eight-ten A board’s composition with respect to its percent- independent members. age of independent directors will be infl uenced by a number of factors, including the size of the What Does “Independent” Mean? board, the number of management-affi liated direc- Under the 1940 Act, independence is defi ned by tors, the legal requirements of the 1940 Act and best statute in relation to affi liations or relationships that practices. make a person an “interested person” of the fund. Section 2(a)(19) provides that an interested person Legal Requirements includes an “affi liated person” of the fund and an Under Section 10(a) of the 1940 Act, all funds “interested person” of the fund’s investment adviser, must have a board of which at least 40 percent subadviser or principal underwriter, a person who of the members are independent directors. has served as fund or adviser legal counsel for the Under Section 10(b) of the 1940 Act, a fund past two years, or a person that owns even a de mini- may not use an affi liated broker or affiliated mus amount of stock of the adviser, the subadviser, underwriter unless a majority of the board is not the principal underwriter, or their control persons, affi liated with the broker or underwriter. such as a public company parent. Th e defi nition If the fund relies on any of the Exemptive Rules, also includes immediate family members of fund a majority of the board must be independent. affi liates. Th e SEC had adopted a provision as part of the Th e SEC can also determine by order that a nat- 2004 Fund Governance Rules that would have ural person is not independent based on a “material required boards of funds relying on any of the business or professional relationship” with the fund, Exemptive Rules to have independent direc- adviser, subadviser or principal underwriter within tors comprising at least 75 percent of the board, the past two years.22 Th e SEC will no longer respond

Copyright © 2015 by CCH Incorporated. All Rights Reserved. VOL. 22, NO. 6 • JUNE 2015 5 to requests for no-action relief in this area because because of their extensive knowledge of the industry, the above provisions require that the SEC fi nd a per- the fund complex and the operations of the adviser son to be an interested person as a result of a mate- and/or underwriter. Nevertheless, prior service as an rial business or professional relationship by order.23 offi cer or director of the adviser or principal under- Although the 1940 Act does not specify what consti- writer may aff ect the director’s independence, both tutes a material business or professional relationship, in fact and in appearance. In particular, it may call SEC no-action letters stress that such a relationship into question whether the former offi cer or direc- would be material if it might tend to impair the tor would be able to eff ectively ‘switch hats.’ 30” Th e independence of a director.24 For example, the Staff advisory group determined not to recommend pro- denied no-action relief when a fund proposed to add hibiting all former employees of the fund’s adviser a new director who could receive economic or pro- and principal underwriter, noting that such a prohi- fessional benefi ts as a result of the relationship.25 bition could lead to “absurd results,” but suggested Additional SEC guidance states that key factors that nominating committees carefully scrutinize the in evaluating whether an individual’s relationships appropriateness of any such individual serving as an might impair his or her independence include the independent director.31 Th e prohibition on former level of that individual’s responsibility or compen- offi cers and directors is not included in the 1940 sation received in positions held with the fund’s Act, which defi nes interested person to includecur- adviser, subadviser or underwriter.26 For instance, rent offi cers, directors and employees of fund advis- individuals who have served as a fund’s portfolio ers, and principal underwriters, as well as those manager within the past two years would have had with a material professional or business relationship a material business relationship with a fund and its within the past two years. investment adviser due to the signifi cant responsibilities such a position entails.27 Depending on the Other Views of Independence facts and circumstances, former directors, offi cers In the fund governance amendments contained and employees of the fund’s adviser, subadviser or in the 2004 Adopting Release, the SEC urged inde- principal underwriter may be viewed as having had pendent directors to look beyond the minimum cri- a material business or professional relationship that teria for independence under the 1940 Act.32 In the would preclude service as an independent director.28 SEC’s view, independent directors should: On the other hand, if the fund’s adviser manages an advisory or brokerage account for a director, but [E]xamine whether a candidate’s personal does not discount its fees or otherwise give the direc- or business relationships suggest that the tor special treatment, this alone would not form the candidate will not aggressively represent basis for concluding that a material business or pro- the interests of fund investors. Persons fessional relationship exists.29 who have served as executives of the fund Under the 1999 ICI Study, the advisory group adviser or who are close family members of took a more expansive view of independence. In par- employees of the fund, its adviser or princi- ticular, the advisory group recommended that former pal underwriter would, in our view, be poor offi cers or directors of a fund’s investment adviser, choices for candidates, although they may principal underwriter or certain affi liates not serve meet the minimum statutory requirements. as independent directors of the fund. Th e report We recognize that “legal” independence acknowledged that former offi cers and directors of does not equate with “real” independence. the fund’s adviser or principal underwriter may be We therefore encourage independent direc- “highly desirable candidates for board membership tors, in selecting and nominating other

independent directors, to identify individu- Appeals for the District of Columbia ruled in favor als who have the background, experience, of the Chamber of Commerce and stayed the eff ec- and independent judgment to represent the tiveness of the provisions requiring mutual fund interests of fund investors.33 boards to be composed of 75 percent independent directors and to have an independent chair.37 In Given the number of factors that may impact a 2006, the SEC sought additional comment on the director’s independence, it is important that boards amendments that were the subject of the litigation, adequately review whether candidates for election or but has not taken further action.38 Whether the SEC existing directors qualify or continue to qualify as will revisit this issue is uncertain. independent. An important part of this process is Although it is not a requirement for a mutual to have candidates and directors complete indepen- fund board to have an independent chair or lead dent director questionnaires on an annual basis and independent director, it is a best practice to do so. to have those questionnaires reviewed for confl icts, As part of the 1999 ICI Study, the advisory group affi liations and disclosure items. identifi ed 15 practices to enhance the independence and eff ectiveness of fund boards, all of which were IV. Independent Chair/Lead endorsed by the ICI’s Board of Governors.39 Among Independent Director the best practices identifi ed by the advisory group While the 1940 Act requires mutual fund was the recommendation that the independent boards to be at least 40 percent independent, there directors designate one or more lead independent is no legal requirement for a board to have an inde- directors.40 pendent chair or lead independent director. Th e Additionally, empirical data suggests that most 2004 Fund Governance Rules would have required mutual fund boards have chosen to have either an mutual fund boards to have an independent chair in independent chair or a lead independent director. order to rely on the Exemptive Rules. In the 2004 An ICI study on mutual fund governance practices Adopting Release, the SEC highlighted the impor- found that 62 percent of investment company boards tant role board chairs play “in setting the agenda had an independent chair at year-end 2012, and of the board, and in establishing a boardroom cul- 88 percent of investment company boards had either ture that can foster the type of meaningful dialogue an independent chair or a lead independent director.41 between fund management and independent direc- Th e number of boards choosing to have either an tors that is critical for healthy fund governance.”34 independent chair or lead independent director has Th e release further noted that an independent chair grown since the ICI began collecting the data. In could play an important role in providing a check 2004, for example, 61 percent of boards surveyed by on the adviser, negotiating on behalf of shareholders the ICI reported having either an independent chair when reviewing the advisory contract, and provid- or a lead independent director.42 ing leadership focused on the long-term interests of Lead independent directors or independent investors.35 chairs can play an important role in setting the Th e United States Chamber of Commerce chal- tone for board meetings and serving as a liaison lenged the 2004 Fund Governance Rule requiring between the independent directors and fund man- an independent chair (and, as noted previously, the agement. Th e responsibilities of the independent requirement that boards have at least 75 percent chair and lead independent director can be similar. independent directors) on the grounds that the SEC As noted above, independent chairs typically set the had not allowed adequate opportunity for public agenda for board meetings, chair board meetings comment on the proposed rule.36 Th e US Court of and carry out other responsibilities set forth in the

Copyright © 2015 by CCH Incorporated. All Rights Reserved. VOL. 22, NO. 6 • JUNE 2015 7 fund’s governing documents. Th e responsibilities of to inclusion not only in principle, but also in practice, a lead independent director can vary from fund to particularly when women and minorities are repre- fund and are often set forth in the fund’s governing sented on the board at more than token levels.48 documents. Lead independent directors often play a Diversity alone should not be the goal in creat- signifi cant role in ensuring eff ective performance of ing or adding to a board; rather, it should be one the board, establishing a strong relationship between of many factors considered when seeking the best the board and fund management and serving as the person for the seat. Even so, it should be one of the single point of contact when the views of the inde- more important factors considered, given the value pendent directors are needed. that diversity can bring to a board and the fund organization. V. Diversity Another issue to consider when assembling a VI. Succession Planning, Retirement board is the diversity of the board, not just in terms of Policies, and Term Limits traditional concepts of diversity such as race and gen- Unlike public operating companies, mutual funds der, but also in terms of diversity of education, profes- are not required to hold annual shareholder meetings sional and cultural background, expertise, viewpoint, and, therefore, mutual fund directors do not stand geography and other attributes. While there is no legal for re-election on a regular basis.49 In the past, it was requirement for diversity on a US mutual fund (or not uncommon for a mutual fund board to allow its other corporate) board,43 proxy statements for the members to serve for an indefi nite term, resulting in election of directors are required to include disclosure lifetime appointments for most directors. Today, with regarding whether and how a nominating committee calls for board refreshment50 and concerns that direc- considers diversity in recommending board candi- tors no longer qualify as independent after 10 years dates.44 Th is, coupled with calls for greater boardroom of service,51 many fund boards are fi nding that having diversity, including from SEC Chairman Mary Jo no policies, or weak policies, to deal with succession White in a recent speech45 and activist shareholders,46 planning is simply not good corporate governance. has a growing number of mutual fund boards making Boards should consider succession planning with an diversity in the boardroom a priority. understanding of, among other things, the 1940 Act Although recent studies provide confl icting requirements pertaining to shareholder approval of views on the relationship between diversity and directors, independence and nomination of direc- fi nancial performance, with some studies fi nd- tors. Considering these issues proactively will enable ing positive correlations between board diversity boards to eff ectively plan for director transitions. and fi nancial performance and others ndingfi the Boards can benefi t from thinking strategi- opposite or no signifi cant correlation, there is some cally about succession planning, taking a holistic evidence to suggest that when diversity is well man- approach to managing director turnover rather than aged, it can improve decision making by lessening dealing with it on a piecemeal basis. For example, the tendency of the board to engage in group think – the board can strive to recruit new members with a phenomenon whereby eff orts to achieve consensus an eye toward fi lling gaps identifi ed through the override the board’s ability to consider alternative annual self-assessment process.52 Th e self- assessment courses of action.47 Th is, in turn, can lead to a more process can also be used as a tool to remove under- engaged, and eff ective, board. Board diversity can also performing directors or those whose skills no lon- enhance the fund’s public image by signaling to share- ger fi t with the fund company’s strategic needs. holders and others that diversity is important to the While most fund boards conduct self-assessments organization, and that the organization is committed of the board as a whole, some boards also evaluate

Copyright © 2015 by CCH Incorporated. All Rights Reserved. 8 THE INVESTMENT LAWYER individual board members through a peer review A disadvantage is that a policy requiring that directors process.53 Conducting peer reviews as part of the step down after reaching retirement age or the end of annual board self-assessment may help to identify their term might require highly productive directors individual board members who are underperform- to leave the board at a time when they continue to ing or who lack the skills or other attributes desired add value to the board.57 In addition, any time a new by the fund company and/or the board as a whole. director is to be added to the board, the fund complex Feedback provided in these circumstances should be must determine whether shareholder approval will be as specifi c as possible, particularly when dealing with required,58 which, if required, can be costly. an underperforming director, so that guidance can Th ere is no “one-size-fi ts-all” solution for board be provided to improve performance. Th e feedback succession planning. Self-assessments may be an should also set forth the time period allotted for such eff ective means to deal with this issue for some improvement before other remedial action will be boards, while age and/or term limits may be another. considered. Because these are diffi cult conversations Th e point here is that this is an issue that should be to have, it might be useful to conduct peer reviews considered by every fund board on a regular basis. anonymously, using outside counsel or another third party service provider who can also facilitate taking VII. Disclosure Requirements action based on the results of the review. Th e board As noted above, mutual fund boards must navigate should also familiarize itself with the fund’s govern- numerous legal and other considerations with respect ing documents to determine if and how the board to nomination and election of directors, director may remove an underperforming director, including independence and diversity. Funds must include pre- whether removal can occur with or without cause. scribed disclosure in SEC fi lings related to these mat- Boards should consider whether to adopt, or ters. For example, funds are required to make certain adjust, tenure-limiting policies, such as age limits, disclosures about the qualifi cations of their directors, term limits or some combination of both. While the fund’s process for nominating directors, and each there is no legal requirement that a fund board have candidate’s relationship with the fund’s adviser and such policies,54 like self-assessments, they can be principal underwriter. Form N-1A and Schedule 14A useful tools to refresh the board. Many fund boards (in the event of a shareholder vote to elect directors) have mandatory age-based retirement policies, but both require the following disclosures for each inde- fewer have term or maximum length of service lim- pendent director or candidate for election: its.55 An advantage to having an age or term limit policy is that this is a predictable manner in which to age, positions held with the fund, length of time facilitate board turnover. It is diffi cult to tell a direc- served in each position, experience and qualifi - tor that he or she is no longer contributing, so age cations and other directorships held during the or term limits provide a handy default mechanism. last fi ve years.59 Term limits in particular can also help avoid erosion a description of any positions held with the of genuine independence that can occur over time, fund’s adviser or principal underwriter or their and can address the longstanding reluctance of some affi liates, or any other investment company or boards to appoint younger directors. An age or term private fund with the same investment adviser limit policy also establishes consistent, objective cri- or principal underwriter as the fund.60 teria for the completion of a director’s service on the a description of any arrangement between the board,56 and makes room for traditionally under- director and any other person pursuant to which represented pools of talent, such as women and that the director was chosen to serve on the minorities, thereby increasing the board’s diversity. board of the investment company.61

ownership interest in the investment adviser or implemented.69 A proxy statement must also dis- principal underwriter of the fund and a descrip- close who recommended each candidate for election, tion of any fi nancial interest in certain transac- including whether the candidate was recommended tions or series of transactions involving the fund’s by a director, offi cer or employee of the fund’s invest- offi cers, investment adviser, principal underwriter ment adviser.70 To the extent a mutual fund has a and offi cers or affi liated parties of the fund’s prin- policy with respect to the consideration of candi- cipal underwriter or investment adviser.62 dates proposed by shareholders, the proxy statement should describe that policy.71 If a mutual fund has a nominating committee, While proxy statements and registration state- Form N-1A and Schedule 14A also require disclo- ments are typically prepared and/or reviewed by fund sure of whether the nominating committee will counsel, directors play an important role in this pro- consider candidates recommended by sharehold- cess. Fund counsel and other service providers rely on ers, and if so, the procedures for submitting such independent directors to provide much of the infor- recommendation.63 mation needed to fulfi ll the relevant disclosure require- Additionally, while mutual funds are not required ments. Th e disclosure requirements are detailed and to have an independent chair, they are required to specifi c. Th e disclosure regime thus demonstrates the disclose in their registration statements whether they importance that the SEC, and shareholders, place on have an independent chair.64 If the board chair is an ensuring a director’s independence and describing the interested person, a fund must disclose whether it process used to select and nominate directors. has a lead independent director and if so, the specifi c role the lead independent director plays in the man- VIII. Conclusion agement of the fund.65 A mutual fund’s registration Creating an eff ective, well-functioning and legally statement must also disclose why it has determined compliant mutual fund board is no easy task. Th ere that its leadership structure is appropriate given its are many variables to consider, and fi nding truly inde- specifi c characteristics and circumstances.66 pendent candidates with the right mix of skills, expe- When a mutual fund submits director candidates rience and willingness to devote the time necessary for election by shareholders, Schedule 14A requires to serve can be diffi cult and time consuming. When the proxy statement to include disclosures describ- assembling a board, or adding to an already existing ing the nomination process. Th e proxy statement board, it is important that all constituencies under- must include a description of the process for iden- stand both the legal requirements as well as the prac- tifying and evaluating candidates including whether, tical issues involved. With these issues in mind, the and if so how, the board (or nominating commit- resulting board should be well-positioned to advocate tee) considered diversity in identifying candidates for shareholders, work together to eff ectively oversee to serve as director.67 In fulfi lling this requirement, fund operations, and fulfi ll its “watchdog” role. the SEC permits mutual funds to defi ne diversity as they see appropriate and recognizes that companies may defi ne diversity to include diff erences in view- Mr. Bausch, Ms. Drought and Ms. Krill point, professional experience, education or skill as are members of the Investment Management well as concepts such as race, gender and national Practice Group at Godfrey & Kahn, S.C., spe- origin.68 If the board (or nominating committee) has cializing in advising various types of invest- a policy with regard to the consideration of diver- ment companies and their boards with regard sity in identifying director candidates, Schedule 14A to regulatory, corporate governance and related requires a description of how the policy is being matters.

NOTES approve procedures governing the transactions 1 Burks v. Lasker, 441 U.S. 471 (1979). and review quarterly reports on transactions); 2 For purposes of this article, the term “mutual fund” (5) Rule 17a-8 (permitting mergers between certain refers to an open-end, registered investment com- affi liated funds if the fund directors, including a pany; however, the governance requirements described majority of the independent directors, request herein apply equally to open-end, closed-end and and evaluate information about the merger and exchange-traded funds (ETFs), although closed-end determine that the merger is in the best interests funds and ETFs may be subject to additional require- of the fund and its shareholders); ments depending on if and where their shares are listed. (6) Rule 17d-1(d)(7) (permitting a fund and Mutual funds are typically organized as corporations or its affi liates to purchase joint liability insur- statutory trusts under state law, and are overseen by a ance policies if the fund directors, including a board of directors or trustees. Th is article uses the term majority of the independent directors, annually “directors” to refer to both directors of corporations determine that the policies are in the best inter- and trustees of statutory or business trusts, and “inde- ests of the fund and its shareholders); pendent directors” to refer to directors or trustees who (7) Rule 17e-1 (specifying conditions under which are not considered “interested persons” of the invest- a fund may pay commissions to affi liated bro- ment company for purposes of the 1940 Act. kers in connection with the sale of securities 3 Independent Directors Council, 2014 Annual on an exchange, including a requirement that Review, p.2. the fund directors, including a majority of the 4 Investment Company Governance, Investment independent directors, adopt procedures for Company Act Rel. No. 26520, July 24, 2004 the payment of the commissions and review [hereinafter 2004 Adopting Release or 2004 Fund quarterly reports of any commissions paid); Governance Rules]. (8) Rule 17g-1 (permitting a fund to maintain a 5 Th e ten exemptive rules are: joint insured fi delity bond and requiring fund (1) Rule 10f-3 (permitting a fund to purchase secu- independent directors to annually approve the rities in a primary off ering when an affi liated bond); broker-dealer is a member of the underwriting (9) Rule 18f-3 (permitting a fund to issue multiple syndicate); classes of voting stock, if the fund board of (2) Rule 12b-1 (permitting use of fund assets to directors, including a majority of the indepen- pay distribution expenses pursuant to a plan dent directors, approves a plan for allocating approved by the board); expenses to each class); and (3) Rule 15a-4(b)(2) (permitting a fund board to (10) Rule 23c-3 (permitting the operation of an approve an interim advisory contract without interval fund by enabling a closed-end fund shareholder approval when the adviser or a to repurchase shares from investors, if the controlling person receives a benefi t in con- directors adopt a repurchase policy for the nection with the assignment of the contract, if fund and review fund operations and portfo- the fund directors, including a majority of the lio management in order to assure adequate independent directors, review and approve the liquidity of investments to satisfy repurchase contract); payments). (4) Rule 17a-7 (permitting securities transactions 6 Th is aspect of the new rules was never implemented. between a fund and another client of the fund’s See Section V. investment adviser, if the fund directors, includ- 7 Role of Independent Directors of Investment Companies, ing a majority of the independent directors, Securities Act Release No. 33-7932, Investment

Company Act Rel. No. 24816, Jan. 2, 2001 [herein- 15 See, e.g., Letter from Marianne Smythe, Director, after 2001 Adopting Release]. SEC, Division of Investment Management to 8 “Report of the Advisory Group on Best Practices for Matthew P. Fink, President, Investment Company Fund Directors, Enhancing a Culture of Independence Institute, SEC No-Action Letter (Nov. 6, 1992). and Eff ectiveness,” Investment Company Institute (“Th e Division will also no longer require an under- (June 24, 1999) [hereinafter 1999 ICI Study]. taking to conduct a meeting to elect directors.”). 9 In the rule proposal, the SEC stated: “[O]ne rec- 16 Section 16(a) of the 1940 Act. ognized method of enhancing the independence of 17 2001 Adopting Release, supra n.7. directors is to commit the selection and nomina- 18 Id. at n.29. tion of new independent directors to the incum- 19 Investment Company Institute, Overview of Fund bent independent directors. Independent directors Governance Practices 1994-2012 [hereinafter 1994 who are selected and nominated by other indepen- -2012 ICI Overview]. dent directors, rather than by the fund’s adviser, are 20 See Rule 0-1(a)(7)(i) under the 1940 Act. See also more likely to have their primary loyalty to share- Chamber of Commerce v. SEC, 412 F.3d 133 (D.C. holders rather than the adviser. In addition, when Cir. 2005) [hereinafter Chamber of Commerce]. independent directors are self-selecting and self- 21 Robert A. Robertson, Fund Governance: Legal nominating, they are less likely to feel beholden Duties of Investment Company Directors, §4.03[1], to the adviser. Th us, they may be more willing to Law Journal Press (2015). challenge the adviser’s recommendations when the 22 Sections 2(a)(19)(A)(vii) and 2(a)(19)(B)(vii) of the adviser’s interests confl ict with those of the share- 1940 Act. holders.” Role of Independent Directors of Investment 23 Better Investing Funds, SEC No-Action Letter (June Companies, Investment Company Act Rel. No. 15, 1988). 24082 (Oct. 14, 1999). 24 See, e.g., Dodge & Cox Balanced Fund, SEC 10 “SEC Chairman Arthur Levitt Proposes Signifi cant No-Action Letter (Dec. 14, 1972). (Citing Senate Reforms to Mutual Fund Governance Structure,” Report 91-189, 91st Congress, 1st session 32) (1968). SEC Press Release 99-31 (Mar. 22, 1999). 25 See, e.g., Alterman Investment Fund, Inc., SEC Independent directors of funds relying on Rule No-Action Letter (Jan. 20, 1980), in which the Staff 12b-1 have been required to select and nominate refused no-action relief when a proposed director of new independent directors since that rule was fi rst an investment company also served as an offi cer of adopted in 1980. a bank that provided banking services to the invest- 11 2001 Adopting Release, supra n.7. ment company. Th e Staff noted that “a serious ques- 12 See Th e Robinson Humphrey Co., SEC No-Action tion could arise as to whether the proposed director Letter (Sept. 4, 1976). (Analyzing the term “selected might stand to gain from accommodating the poli- and proposed for election” in Section 16(b) of the cies or wishes of the controlling directors on the 1940 Act and concluding that the independent company’s board as a means of assuring the continu- directors had not been properly selected by the other ity of the banking relationship.” independent directors.). 26 Interpretive Matters Concerning Independent Directors 13 See Section VI regarding succession planning strategies. of Investment Companies, Investment Company Act 14 Dreyfus Conn. Municipal Money Market Fund, SEC Rel. No. 24083, Oct. 14, 1999. No-Action Letter (Dec. 5, 1990). (“For 35 years, it 27 Id. has been the staff ’s position that an investment com- 28 Id. pany will not comply with Section 16(a) unless its 29 Id. public shareholders elect the board of directors.”). 30 1999 ICI Study, supra n.8 at 12.

31 Id. at 23. 47 See Deborah L. Rhode & Amanda K. Packel, 32 2004 Adopting Release, supra n.4. “Diversity on Corporate Boards: How Much 33 Id. See also ns.50-51, infra, and related text. Diff erence Does Diff erence Make,”Delaware Journal 34 2004 Adopting Release, supra n.4. of Corporate Law, 39, No. 2, Fall 2014, at 377-425. 35 Id. 48 Id. 36 Chamber of Commerce, supra n.20. 49 In contrast to mutual (open-end) funds, directors of 37 Id. at 33. closed-end funds or ETFs listed on stock exchanges 38 Investment Company Governance, Investment do stand for re-election on a regular basis (typically Company Act Rel. No. 27395 (June 13, 2006), every three years if the board is classifi ed, or annually, Investment Company Governance, Investment if the board is not classifi ed). Company Act Rel. No. 27600 (Dec. 15, 2006). 50 See Deborah DeHaas and Maureen Bujno, “Board 39 1999 ICI Study, supra n.8 at 4. Refreshment: Addressing Shareholder Concerns,” 40 Id. at 34. National Association of Corporate Directors (Feb. 2, 41 1994 -2012 ICI Overview, supra n.19 at 1. 2015), http://www.nacdonline.org/Magazine/Article. 42 Id. at 11. cfm?ItemNumber=13157. 43 Although there is no such requirement in the United 51 For example, proxy advisory fi rm Institutional States, more than a dozen other countries have Shareholder Services has increased its focus on implemented quotas to increase women’s representa- this issue through its governance rating system, tion on boards, and many more have adopted volun- QuickScore 2.0, which views tenure of more than tary quotas in their corporate governance codes. See nine years as an “excessive” length that potentially Susan Franceschet & Jennifer M. Piscopo, “Equality, compromises director independence. Similarly, the Democracy, and the Broadening and Deepening of Council of Institutional Investors now includes ten- Gender Quotas,” 9 Pol. & Gender 310, 311 (2013). ure as a factor in determining director independence. 44 See Rule 407(c)(2)(vi) of Regulation S-K, made appli- Many foreign jurisdictions support limiting director cable to funds by Rule14a-101(22)(b)(15)(ii)(A) tenure as well, such as the European Commission, under the Securities Exchange Act of 1934, as which recommends that European Union-based com- amended (i.e., Schedule 14A), discussed in the text panies limit director tenure to 12 years or three terms. accompanying ns.67-69, infra. 52 As mentioned in Section I, fund boards relying on 45 See Yin Wilczek, “SEC Chairman Calls on Companies, the Exemptive Rules are required to conduct an Shareholders to Help Increase Number of Women annual self-assessment. See Rule 0-1(a)(7)(v) of the Directors,” Bloomberg BNA, Sept. 19, 2014. 1940 Act. 46 In a recent report on board gender and diversity, 53 According to the IDC, peer reviews are still rather proxy advisory fi rm Glass, Lewis & Co. stated that uncommon, with 77 percent of fund complexes hav- “Investors are aware of the risks presented by ‘group ing no formal policies, or only general policies, on think’ among board members and are pressing compa- peer reviews; 16 percent of fund complexes where nies to ensure that boards provide more eff ective over- peer reviews occur, despite no formal policy; and only sight by asking challenging questions. It is believed 7 percent of fund complexes having a formal peer that new and diff erent ideas will likely come from review policy. See Independent Directors Council, boards that are diverse in race, gender, background, “Considerations for Board Composition: From and experience … .” Glass, Lewis & Co., “In-Depth: Recruitment through Retirement,” (Oct. 2013) [here- Board Gender Diversity” (April 2013), available at inafter IDC Board Composition Report], avail- http://www.glasslewis.com/assets/uploads/2013/04/ able at http://www.idc.org/pdf/pub_13_considerations_ Glass-Lewis-In-Depth-Board-Gender-Diversity.pdf. board_comp.pdf.

54 Th e Mutual Fund Directors Forum (MFDF), in its allow the director to be a nonvoting board member July 2004 report entitled “Best Practices and Practical for a period of time. Guidance for Mutual Fund Directors,” suggested as 58 See Section II. a best practice that a fund’s directors annually assess 59 Form N-1A Item 17(a)(1); Schedule 14A Item the fund’s retirement policy, if it has one, as well as 22(b)(1)-(2). the eff ectiveness of that policy, or consider whether 60 Form N-1A Item 17; Schedule 14A Item 22(b)(4). to adopt a retirement policy if it doesn’t already have 61 Form N-1A Item 17(a)(3); Schedule 14A Item one. In doing so, MFDF suggested that directors 22(b)(3). determine what factors, such as age, years of service 62 Form N-1A Item 17(b)(5)-(10); Schedule 14A Item and other criteria, are relevant to a retirement policy. 22(b)(5)-(9). 55 According to the IDC, an increasing number of fund 63 Form N-1A Item 17(b)(2); Regulation S-K Item complexes have adopted mandatory retirement policies, 407(c)(2)(iv), made applicable to funds by Schedule from 45 percent in 1996 to 67 percent in 2012, with 14A Item 22(b)(15). an average mandatory retirement age of 74. Some boards 64 Form N-1A Item 17(b)(1). specify terms for board service, but this practice is uncom- 65 Id. mon and may be more relevant for boards with younger 66 Id. directors who might be able to serve for a number of years 67 Regulation S-K Item 407(c)(2), made applicable to (e.g., 30 years) before reaching a mandatory retirement funds by Schedule 14A Item 22(b)(15). age. See IDC Board Composition Report, supra n.53. 68 Proxy Disclosure Enhancements, Securities Act Release 56 While exceptions to such policies can certainly be No. 33-9089, December 16, 2009. made, to ensure consistency and predictability, such 69 Id. exceptions should be rare and should apply to all 70 Regulation S-K Item 407(c)(2)(vii), made applicable board members. to funds by Schedule 14A Item 22(b)(15). 57 If this is a concern, a board could consider granting 71 Regulation S-K Item 407(c)(2)(ii)-(iii), made appli- an outgoing director emeritus status, which would cable to funds by Schedule 14A Item 22(b)(15).

Copyright © 2015 CCH Incorporated. All Rights Reserved Reprinted from The Investment Lawyer, June 2015, Volume 22, Number 6, pages 1, 4–15, with permission from Wolters Kluwer, New York, NY, 1-800-638-8437, www.wklawbusiness.com